Tax planning and compliance for investors
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By Kaye A. Thomas
Updated January 24, 2008
A way to save tax dollars if the value of your Roth IRA declines after a conversion.
The amount of tax you pay on your Roth IRA conversion is based on the value of your IRA at the time you convert it. If your Roth IRA went down in value after you converted, it may make sense to undo the conversion and reconvert at a lower value. This maneuver won't recover your market losses, but at least you won't be paying tax on money that's no longer in your Roth IRA.
Any amount that was converted to a Roth IRA and then switched back to a traditional IRA in a recharacterization can't be reconverted in the same year as the original conversion, and also can't be reconverted within 30 days of the of the recharacterization. But there are still some valuable planning opportunities for people who suffer market losses after a conversion.
It ordinarily won't make sense to undo a conversion until you get near (or past) the end of the year of the conversion. At that point you may decide that the post-conversion loss in your Roth IRA is greater than any recovery you can reasonably expect in a 30-day period, and decide to undo the conversion, with a plan of redoing it 31 days later.
Example: You convert your $100,000 traditional IRA to a Roth IRA in February. To your chagrin, the Roth IRA has lost 40% of its value by June. If only you had waited! As things stand, you'll have to pay tax on $100,000 next April, even though only $60,000 of that amount remains in your IRA. You can still undo the conversion any time until October 15 of the year following the conversion. But you have to wait until the year after the original conversion to redo it, and the time between undoing it and redoing it has to be at least 30 days.
Suppose you undo the conversion in June, after the 40% reduction in value. You would have to wait until January of the next year to redo the conversion. It's possible the investments will recover by then, perhaps even be higher than the original $100,000. You would end up paying even more tax than if you had left the conversion in place! But if you wait until at least December 1, you can undo the conversion and then redo it just 31 days later. That may not be as good as being able to flip back and forth immediately, but it can still work to your advantage if the market losses are substantial as of that point in time.
Bear in mind that when you redo the conversion, it's a completely new conversion in the new year. You can't reinstate the original conversion. You have to qualify for a conversion in the year in which you redo the conversion. And if your tax bracket increased from the year of the original conversion to the year of the reconversion, you'll pay the higher rate when you reconvert.
If you do a partial conversion, you have greater flexibility in undoing a conversion and (effectively) redoing it. That's because the rule delaying the reconversion only applies to the amount that was originally converted. It doesn't apply to an amount that wasn't previously converted.
Example: You converted $20,000 of a $60,000 traditional IRA to a Roth IRA. Shortly afterward you found that the value of the Roth IRA had shrunk to $15,000. Using the recharacterization rules, you undo the conversion, transferring the contents of the Roth IRA to a new traditional IRA. The same day, you convert another $20,000 from the old traditional IRA. This is permitted because you have not previously converted this amount — even though you previously converted another amount from the same traditional IRA.
In this example, you use a new traditional IRA to undo the Roth conversion. That isn't required, but it makes it easier to be clear that the amount you're converting hasn't been previously converted. The regulation says you have to adjust the any amount previously converted for the net income on that amount, but doesn't give details as to how you should do that. The best way to be clear about this is to use a new traditional IRA for the recharacterization.
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