Roth Recharacterization – FAQs

by Neal Frankle, CFP ®

A Roth recharacterization is a “do-over.” It’s undoing a Roth conversion. If you do a Roth recharacterization, you have until October 15 of the year after you convert to a Roth to undo it. (Read “IRA Restrictions.”) So if you converted to a Roth in 2010, you have until October 15, 2011, to undo it.

Why would you want to recharacterize your Roth?

It could be very smart financial tax planning for a few reasons.

First, if you converted your IRA to a Roth and then the value of the Roth declined because of the market, you’d consider undoing it. Example: You converted your $100,000 IRA to a Roth in January 2010. When you did the Roth conversion, you paid the government $25,000 in taxes. You let your brother-in-law mange the money. He convinced you he knew the best IRA investments. But because of his “genius investing skills,” the account is now worth about $50,000. You’d like to undo the Roth conversion and get back that $25,000 you paid in taxes, so you want to recharacternize (undo) your Roth.

Here’s another reason you’d recharacterize your Roth. Let’s say you receive a bonus at the end of the year, pushing your modified adjusted growth income (unexpectedly) over the $100,000 limit. You converted the Roth when you thought your income was below the limit, but your pesky employer awarded you that bonus and now you realize that you should not have made the conversion because you don’t qualify. In this case, you have to undo the Roth.

How do you recharacterize your Roth?

Simply do a trustee-to-trustee transfer into a traditional IRA. It’s easy. If you decide to do this, just let your IRA custodian know and they’ll take care of it.

What happens if you make an excess Roth conversion and don’t redo it in time?

If you do that, you’ll make your friends at the IRS very unhappy. Then, they’ll make you very unhappy.

The amount that should have been recharacterized (but wasn’t) will be taxed as an IRA distribution. You’ll pay income tax on the money and perhaps a 10% penalty if you are under age 59 ½. On top of that, you’ll pay a 6% penalty each year the money is parked inside that Roth. (Read “IRA FAQ.”)

What are the major mistakes in recharacterizations?

If I was feeling cheeky, I’d say that the biggest mistake you can make with Roth conversions is doing one in the first place (if you are going to use the IRA itself to pay the tax). Seriously, if you recharacterize your Roth and plan on using the IRA itself to pay the tax, you can get into hot water very quickly.

Let’s say you convert $100,000 from your IRA to a Roth. You owe $25,000 in taxes on this $100,000 you withdraw. You roll $75,000 from your IRA to your Roth and use the remaining $25,000 to pay the tax (since you don’t have other savings). Then you learn that you have to recharacterize the Roth, but your $75,000 has dropped in value to $60,000 (remember the brother-in-law genius investment manager?)

You can’t put the entire $85,000 back into your IRA ($60,000 account value plus $25,000 in taxes you paid). You can only roll back the $60,000. You’ll get the $25,000 in taxes back, but you can’t roll it back to your IRA and oh yes…you’ll have to pay taxes on the $25,000 too.

The bottom line? If you are going to recharacterize your Roth, make sure you talk to a qualified professional before you do anything. There are simply too many landmines out there waiting for you to step on.


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