Roth IRA Conversion has a Valuable Un-Do Option

Starting in 2010, the income limit for converting a traditional IRA to a Roth IRA has been removed. Before this year, only those people with modified adjusted gross income of $100,000 or below could convert. It is generally favorable to convert at least some money to a Roth this year if:

– You expect to pay higher taxes in the future. For example, if you own a traditional IRA with $3 million or more, it is quite likely you will be in a higher tax bracket after you reach the age of 70 when IRA minimum distributions are required (RMDs) based on your life expectancy. I have a large amount in traditional IRAs and plan to do a partial Roth conversion every year until I reach the RMD age.

– Have a long investment time frame: Generally favorable if you have 10 years or more before you need to start taking distributions. This is because you will experience a longer period of tax free growth.

– Can pay the taxes on the distribution with outside money. Using the proceeds of the distribution to pay the taxes is a big mistake if you are under 59 ½ because there is a 10% penalty.  But even if you are over 59 ½, it is still not advisable, because it reduces the amount that can grow tax-free in the Roth IRA.

There is a valuable “do-over” or “un-do” feature available whenever you do a Roth conversion. The process is known as a Roth recharacterization. It allows you to cancel the amount converted from a traditional IRA to a Roth IRA and recover the taxes you paid. The deadline for this is October 15 of the following year. When doing a Roth conversion, it is best to open up a new Roth IRA and keep it separate from any other Roth IRAs you may have had before. This makes the recharacterization process much simpler.

Here are some reasons why you would want to recharacterize a Roth conversion:

–         The value of the Roth IRA drops considerably. For example, let’s say you are in a 35% tax bracket and you converted $100,000 to a Roth IRA. One year later, the Roth portfolio has dropped to $80,000. If you do nothing, you will owe $35,000 in taxes. By recharacterizing the Roth IRA back to a traditional IRA, you save the $35,000 in taxes. Now if you wait at least 30 days, you can re-convert the $80,000, and the tax bill would only be 35%*(80,000)= $28,000, so you would save $7,000 in taxes.

–         If your taxable income was much higher than you expected, and the income from the Roth conversion pushes you into a higher tax bracket, you may want to “un-do” it.

–         If you determine that your future income in retirement will be much lower than you expected, this will reduce the benefit of the Roth conversion, so you may want to “un-do” it.

–         You do not have enough cash reserves to pay the taxes.

If you don’t mind the extra paperwork, you can do multiple Roth IRA conversions each year. One idea is to use different non-correlated strategies for each Roth IRA. Let’s say you do two Roth IRA conversions of $50,000 each. Call them Roth A and Roth B. Suppose one year later, Roth A is worth $70,000 and Roth B is worth $40,000. You can choose to “un-do” the Roth B conversion and re-capture the taxes you would have paid on the $50,000. You keep Roth B which is now worth $70,000, even though you only have to pay taxes on $50,000. Make sure that each Roth IRA is separate when you use this approach.


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