Even if you consult your financial advisor or CPA, she might not have all the answers when it comes to a Roth IRA re-characterization. That’s understandable. The world of IRA restrictions is vast. But if you have a clear understanding of this issue, you might be able to make some extremely helpful financial moves.
What is a Roth IRA Re-characterization and How is it Useful?
Most people consider a Roth IRA re-characterization when the market drops significantly after the initial conversion. That could make a lot of sense and here’s why. Let’s say you converted your IRA when it was worth $100,000. For our purposes, let’s say you paid the tax on the conversion with money outside the IRA so the entire $100,000 was rolled into the Roth. But because the market dropped significantly, your Roth is now only worth $70,000. That stinks because you paid the tax on the $100,000 but only have $70,000.
You can re-characterize the conversion, put the Roth money back into a regular IRA and recoup the tax you paid. If you do this, it’s as if you never converted the IRA to a Roth. Think “do over”.
What Your CPA May Not Know
CPA’s are sometimes confused and think that this person would have to put the full $100,000 back into the IRA in order to recoup the taxes paid but that’s not true. The full value of the $100,000 conversion is now $70,000. As long as you re-characterize the full value, you won’t have to pay the IRA Roth conversion tax on the initial $100,000.
Now, even though this is the primary reason people reverse the Roth conversion, you can re-characterize for any reason you want. Also, you are allowed to re-characterize only part of your Roth if you so desire. It’s not an all or nothing proposition.
You have a very long period of time to consider the re-characterization. In fact, you have until October 15 of the year after you make the conversion to get it done generally speaking. If the 15th falls on a weekend, you usually have a few extra days to complete this process.
Once you decide you want to re-characterize your Roth conversion, you have to be very careful. Don’t take the money out of the Roth and deposit it into the IRA. Do a direct transfer from the Roth to the traditional IRA custodian. The nice thing is you can do this even if the original money came out of a company plan. And you can re-characterize the money to any IRA – not only the one you took the money out of in the first place.
Even if you’ve already filed your tax return you can still move ahead with the re-characterization. All you have to do is amend your tax return.
Did you ever consider a Roth IRA re-characterization? What was most confusing to you? Have you exposed any other myths about Roth IRA conversions?