Undo a Roth IRA Conversion For Profit – Tips & Tricks

Did you know that if you do a Traditional to Roth IRA conversion, that you can undo it? This “do-over” process is called recharacterization, and can come in very handy if the value of your investments drop significantly after your conversion since you owe income taxes based on the value of the IRA at the time of conversion. With the recent market volatility, this may apply to many investors as it did previously in 2008/2009.

Take the example below, from a 2009 CNN Money article but still applicable. Let’s say you had a Traditional IRA valued $150,000 at conversion, which later on drops to $100,000. At the end of the year, you’d have to pay taxes on $150k of income and also be stuck with the lower account value. By performing an “undo” and “redo” the conversion, you could pay income taxes on only $100,000 of income instead of $150,000 – a savings of $14,000 at the 28% tax rate. (Find your 2010 tax bracket.)

There are some ground rules, however. The IRS says you can perform a recharacterization until October 15th of the year following the year you converted. So if you converted in April 2010, you have until October 15, 2011. If you want to re-convert, you have to wait either 30 days after the recharacterization or until the tax year after the conversion year, whichever is later. Again, if you converted in April 2010, you’d have to wait until January 1st, 2011 to reconvert. If you wait too long in between, it is possible your account value might be even higher than before. Still, something I’ll be keeping an eye on.

(You must still meet the Roth conversion eligibility rules, previously based upon your modified adjusted gross income. In 2010, there are no income limits. In 2011 and beyond, there currently are no income limits either, but it is unknown if this will remain the case. Also, only for 2010 conversions are you allowed to split the income over 2011 and 2012, which can lower your overall tax bill based on tax brackets.)

More Advanced: Multiple Roth IRAs

How can you set yourself up to best take advantage of this “redo” opportunity? I recently read in a sample issue of Kiplinger’s Retirement Report that you should split your Traditional-to-Roth conversion into multiple IRAs for each asset class you own.

For example, you might split a $200,000 IRA into $100k of stocks and $100k of bonds. If the stocks go down to $80k while the bonds go up to $120k, just to a “redo” on the stock IRA and leave the bonds IRA alone. Assuming the values stay the same upon re-conversion, that would save you income taxes on $20,000 ($5,600 at a 28% tax rate) as compared to not splitting up the IRA since if you just converted it a single IRA, the total value remained $200,000 ($80k+$120k). Tricky!