Why You Might Want To Recharacterize Your 2010 Roth IRA Conversion

After all the hoopla around Roth conversions in 2010, now is the time to consider whether or not a recharacterization is in your future.  So what is a recharacterization, and how does it work?

Recharacterization is the “backing out” of your Roth conversion.  In other words, you can literally make the conversion as if it had never been done at all, with your money back in the traditional IRA where it started.

[See Jim’s tips on Paying Taxes on a Roth IRA Conversion]

Why would you want to do that?  Here’s an example: let’s say you converted $100,000 to a Roth IRA in 2010 and you are ready to pay the tax on your 2010 return (you elected out of the spread to 2011 and 2012).  Except that now, your investment in the Roth IRA has dropped in value to only $50,000 – and you still owe tax on the conversion of $100,000!  Yikes – that’s just totally wrong!

Recharacterization can help to save you in this situation.  As long as you act before the due date of your return (including extensions), you can put recharacterization to work for you, moving the $50,000 back to the traditional IRA.  It will be as if nothing was done at all, and no taxes are owed.

Actually, as far as the IRS is concerned you are not moving $50,000 back, you’re moving the original $100,000 and the gains or losses on that original $100,000, which happens to equal $50,000.

Recharacterization Strategy

One way to use this to your advantage is to split your Roth conversions up into separate accounts by specific types of assets, so that if one of the asset types (or more) happens to drop significantly in value, you can recharacterize the conversion on only that account, leaving the other account(s) intact.

This would help with your record-keeping, since any amount that you recharacterize from a Roth to a traditional IRA must include the gains or losses that are attributable to the recharacterized amount.  Of course, you wouldn’t likely recharacterize unless you had net losses in the Roth account – although you might find that recharacterization is a good option if you came up short of cash to pay the tax on the original conversion.

About the author

Jim Blankenship, CFP®, EA

Jim Blankenship is the founder and principal of Blankenship Financial Planning, Ltd., a financial planning firm providing hourly, as-needed financial planning and advice. A financial services professional for over 25 years, Jim is a CFP professional and has earned the Enrolled Agent designation, a designation that qualifies him as enrolled to practice before the IRS. Jim is also a NAPFA-registered financial advisor, which designates him as a Fee-Only Financial Advisor.

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15 Comments

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  • Jenny,

    Unfortunately, the time of payment of tax isn’t the key here, it’s when the return was due, which would have been October 15, 2011. You needed to recharacterize by that date for the 2010 conversion, regardless of when the tax is actually paid.

    jb

  • Hi Jim,

    I did a conversion from traditional ira to roth ira on 2010, and elect to pay tax on 2011 and 2012. Is it still possible for me to roll this back now (I know it already passed Oct. 15 2011, but I haven’t paid anything yet)

    Thanks,
    Jenny

  • Dave the CFP –

    Sounds like a workable plan.

    I don’t know of any reason why this wouldn’t work for you, unless your two funds aren’t well-aligned (exact opposites) and some traumatic event caused them both to crash – although if that happened you could just recharacterize the whole thing and then start over, albeit with a smaller nest-egg.

    Best of luck to you –

    jb

  • So Jim,
    If I convert my $200k IRA into two separate roths, then put one in a 2x leveraged bull fund and one into a 2x leveraged bear fund, if the market loses 20% I will have one fund up 40% and one down 40%. I have incurred no loss. I recharacterize my losing fund to a 60K trad IRA, then I keep the winning fund, up $40k tax-free (and maybe go to a safe balanced fund.) Net: I have a 40% tax-free profit and a 40% pre-tax loss by determining the winner after the fact and I have paid taxes on half of the original conversion. Next year I do this again on the 60k left in the Trad IRA.

    Do you see any problems?

    -Dave the CFP

  • Christine,

    I’d say you probably should in order to correct Form 8606, which would be different when you’ve recharacterized. If you don’t do this, the IRS will want to know why you’re not paying tax on half of the converted amount on your 2011 tax return.

    jb

  • Jim,
    I did a roth conversion in November, 2010 that has dropped significantly in value. When I filed my 2010 taxes I elected to spread the taxes due over 2011/2012, so essentially I have not paid any taxes yet. If I undo this conversion before October 15, 2011, do I still need to file an amended tax return? Thanks for your help.

  • Faye,

    If the stock has not produced any dividends during the period that it has been converted into Roth, then your strategy of just moving the 500 shares of stock back into the IRA would accomplish the recharacterization.

    If the stock has produced any income in the form of dividends or capital gains distributions (or has split) then you need to make sure every bit of the money attributed to the stock is moved back into the IRA.

    Hope this helps –

    jb

  • Eugene, you should be able to recharacterize the rollover such that in the end the funds (and any gains or losses) are in a traditional IRA rather than a Roth IRA. What you heard may be related to recharacterizing back into the 401(k) plan – plan sponsors may not allow this.

    Essentially what you are doing with this recharacterization is changing the nature of the distribution from a Roth conversion into a simple rollover to an IRA.

    Hope this helps –

    jb

  • I converted 500 shares of stock $10000 value to Roth Ira value dropped to $6000. Can I recharcterize by just moving 500 shares of the stock and not pay taxes or do I have to move $10000 money or stock?
    Thanks

  • Jim–I did a partial conversion of my 401K in 2010. I put the money into 4 separate new Roth IRAs. I also filed for an extension of my 2010 income tax return so that I didn’t have to file it until Oct 15, 2011. My intent was to give myself the opportunity to recharacterize one or more of my Roth IRAs, depending upon market performanc. Well, you know what the market has done recently and I was contemplating one or more recharacterizations. I was recently told that you can only recharacterize a Roth IRA conversion from a traditional IRA, not one from a 401K. Is that correct?

  • Byron –

    You can recharacterize your Roth conversion by putting the proceeds from the conversion, plus or minus any gains or losses attributed to the investments you made within the Roth account, back into the traditional IRA.

    You need to do this by October 15 for the tax year 2010. You’ll also need to amend your tax return for 2010 to show that the conversion was not done. You have three years from the due date of the return to get the amendment done, but you’ll want to do it right away so that you don’t have to do a lot of explaining with your 2011 return.

    If the amendment hasn’t been processed by the time you file your 2011 return, the IRS is going to want to know why you didn’t include the tax paid on half of the conversion amount.

    Hope this helps –

    jb

  • I did an IRA to Roth conversion in 2010 and elected to pay the taxes in 2011 and 2012. Can I undo all this back to an IRA and not have to pay the taxes. If so, when will I need to do this.

  • Thanks for pointing out the incorrect information, John. We’ll get the article fixed up.

    This just goes to show that you can learn something new every day.

    jb

  • Jim, you state that “This is because recharacterization is an all-or-nothing proposition – if you are going to recharacterize a Roth conversion, you have to recharacterize the entire conversion into that Roth account, along with the gains or losses that are attributable to the converted amount.” I’M SORRY, BUT THIS IS SIMPLY NOT TRUE. I made 7 partial Roth IRA conversions totaling $155K during the first quarter of 2009 as the market kept declining. (I had opened a dozen new separate Roth IRA conversion accounts–with zero balances–with my broker at the end of 2008 expressly for this purpose. I knew that I would be in a low tax bracket for 2009 and planned to convert a net amount of about $50K during 2009, betting that there would be a significant rebound over the ensuing 15 months–or 21 months with extension, if I needed it.) In March 2010 I kept the best performers and recharacterized the remaining accounts with the utmost precision: I calculated to the dollar how many conversion dollars to keep and how many to recharacterize in order to “fill up”–but not exceed–the 15% tax bracket (i.e., $67,900 taxable, for a 2009 joint return). In my case, this meant keeping accounts #5, #6 and #7, and only a PORTION of #4. It was a simple calculation to determine the percentage of the value of account #4 to recharacterize to achieve my objective. In the end, I recharacterized about $104K of the original $155 conversion amount. The same strategy was executed in 2010, and is in progress for 2011 as well.

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