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?

photo credit: Patrick Gage

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.

photo credit: chocolategirl64

Securities offered through LPL Financial, Member FINRA/SIPC.