If you make a Roth conversion early in a calendar year and then for some reason discover that your AGI will exceed the $100,000 threshold, then the tax law allows you "re-characterize" your Roth and have the money rolled-back into your regular IRA without a penalty.

How many times in your life do you wish you had a “do over” or “take back“.

Often times your stuck with the decision you made and the repercussions that come along with it.

When it comes to investing, many of us have made mistakes over the years. Whether is was underfunding your retirement plan or buying that “hot stock tip” that turned into a disaster; these are decisions that are irreversible.

One decision that does allow you to cash in a “redo” is the Roth IRA conversion.

For those that may have converted their Roth IRA prematurely, here’s what you need to know to reverse it back to a traditional IRA better known as a “Recharacterization“.

Here are the rules on the IRA Recharacterization that you need to know.

Recap of 2010 Conversion Event

If you haven’t heard of the 2010 Roth IRA Conversion event, then you obviously haven’t visited my blog before. That’s okay, I forgive you.  :) While 2010 is the actual year that you will be able to convert, the income to be claimed can be deferred until 2011 and 2012.  Expecting a vast majority to take advantage of this, the IRS has set up special provision on how the tax will be paid.  The IRS has granted you the option to claim 50% of the conversion amount as income in 2011 and the remaining 50% in 2012.  Keep in mind that this is only in 2010.  After 2010 the taxes will all be paid in full the following year going forward.

If you elect to pay the tax over the two year period, keep in mind that the tax rate is determined for that year only.   Example, in 2011 you will pay the tax based on your tax bracket for that year.   If your income were to somehow sky rocket in 2012, then you will be paying more in taxes that year for the conversion.

Why Would Your Recharacterize a Roth IRA Conversion?

That’s a great question!  With the Dow Jones hovering around 10,000 again, I hope that you won’t want to do a Roth IRA recharacterization in the next few years.  Most pe0ple that have reversed a Roth IRA Conversion have done so for the following reasons.  At the time of conversion, the account value of your traditional IRA is what you have to add as ordinary income for that year.  If you executed a Roth IRA conversion early in 2008 when the Dow was still at respectable levels, the Recharacterization is a godsend.  Why?  Because you can reverse the conversion when your account balance was higher and now reconvert at a lower amount.  In essence, that means you will pay less income tax on the conversion.  How’s that for a redo?

Did You Miss The Deadline?

As with any great coupon, there is usually an expiration date.  The recharacterization is no different.  You have until October 15th of the calendar year after the year you converted to recharacterize.  For those wanting to reverse your conversions of 2008; sorry, but it’s too late.

For future reference, if you are trying to recharacterize a conversion from a Roth back to a traditional IRA you are not allowed to reconvert back to a Roth within the same tax year or within 30 days of the IRA recharacterization.

In other words, an IRA that has switched to a Roth earlier this year and then switched back can’t be reconverted to a Roth this year. The reconversion has to be delayed until at least January 1 or if later, 30 days after the IRA was switched back to the traditional.

Rules on How Report the Recharacterization

To reverse the conversion, first step is to contact your IRA custodian.  For example, most brokerage firms will have their own in house paperwork to complete.  The next step will depend if you have filed your tax return or not.  If you have yet to file, just updating form 1040 will take care of it.  If you have already filed, you’ll have to file an amended return with form 1040x and you’re back to the drawing board.

Recent Recharacterization Question

Is a re characterization based on the dollars of the stock shares or stock shares only? – Here is my situation: in 2010, I moved 10,000 shares of company ABC stock in my traditional IRA to a newly opened Roth IRA (My Roth account was credited 10,000 shares (not dollars value), since I did not sell the stock when I did the transfer). My expected hope at that time was that the stock would appreciate in value within a year, then I could pay tax on the 10,000 shares valued at the time of the conversion to Roth and would realize a gain without a tax burden in Roth IRA.  Unfortunately for me, the stock price did not go up but declined substantially.  

As a result, I requested my brokerage service to re convert (or re characterize) 10,000 shares of ABC from Roth to traditional IRA in April of the following year 2011.  The re characterization was completed successfully. 

However, my brokerage service firm reported the IRA conversion in $ amount (but not the # of shares).  Since the $ value of 10,000 shares at the time of re characterization done in April 2011 was substantially less than the value at the time of moving from Traditional IRA to Roth IRA in 2010.  

Do I owe tax on the difference of the $ values? Was my re characterization of 10,000 shares completed correctly without tax consequence?  I would like to stress that I did not trade the stock during the entire time the stock was in my Roth IRA.  I just simply move 10,000 shares from Traditional IRA to Roth and revert them back from Roth to traditional IRA.

1) All Roth conversions and recharacterizations are reported in dollars. If you tell the custodian the number of shares you want converted they will report the value of those shares on the 1099R and you must report that value in your income. When you recharacterize, you should request the recharacterization in terms of the dollar amount of your original conversion you want recharacterized.

In your situation, you converted into a new Roth IRA rather than an existing Roth. A full recharacterization of such a conversion is simple in that no earnings calculation must be done to calculate the investment results of the entire Roth since the Roth does not hold anything other than your conversion. Therefore, this Roth IRA presently should have a -0- balance, and the reduced value of those shares is now back in your TIRA account. You have eliminated the tax bill on your conversion. I assume that there were no dividends paid on the stock while it was in your Roth IRA.

2.  My second question is how many times can I move back and forth between Roth and Traditional IRA just like I did in 2010 and 2011?  Is there any rule that limits the number of conversion from Roth-to-traditional IRA’s (and re characterization) in 1 year or in one’s lifetime?

2) There is a time limit to reconvert the same assets. That time limit is either 30 days from the recharacterization date or Jan 1 of the year following the conversion, whichever is longer. Since your other conversion was in 2010 and you recharacterized it April, 2011, you could have reconverted 30 days after the April recharacterization.

You did not have to wait until 2012 because your recharacterized conversion was a 2010 conversion, not a 2011 conversion. This is the only waiting period and it only applies when reconverting the same assets. People with large IRAs that do partial conversions can convert other amounts in their IRA without a waiting period.

Note that you must report your activity on your tax returns when you recharacterize. For 2010 you should have filed Form 8606 to report your conversion, unless you filed after you recharacterized it. If you filed after you recharacterized the conversion, you did not need an 8606, but should have included an explanatory statement with your 2010 return indicating the dates and amounts of both the conversion and the date and amount of the recharacterization and how much is was worth when transferred back to the TIRA.

Neither you or the IRS received the 1099R for the recharacterization until January, 2012 but that 1099R should have been coded to indicate that you recharacterized a 2010 conversion. Since this all applied to 2010, your 2011 return does not have to reflect anything further about this recharacterization.

If you don’t include explanatory statements, the IRS may have trouble understanding what you did and how much of your conversion is recharacterized.

Creative Commons License photo credit: chocolategirl64


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