By Jason Alderman
We’ve all suffered er’s remorse – say you something you really can’t afford or the item’s sudden drop in value make it seem, in retrospect, a poor investment. That’s what has happened to some people who’ve taken advantage of IRS rules that allow them to convert a regular IRA or 401(k) into a Roth IRA, only to discover later it may not have been the right strategy.
In this particular situation, however, the IRS graciously allows for a do-over, called a Roth IRA “recharacterization.” Read on to learn how recharacterizations work, and whether you may be a good candidate.
First, a brief primer on IRAs. With regular IRAs you contribute pretax dollars, which lowers your current taxable income so you pay less tax now. Your account grows, tax-free, until you withdraw the money at retirement, when you pay income tax on withdrawals at your tax rate at the time. By contrast, with Roth IRAs, you’re taxed on your contributions during the current year, but all withdrawals, including investment earnings, are tax-free at retirement.
The IRS allows taxpayers at any income level to convert part or all of their regular IRAs or 401(k) plans to Roth IRAs. (Prior to 2010, higher-income people were excluded.) Although such conversions can provide long-term tax advantages – especially for younger people – they can be expensive in the short term, as I experienced first-hand when I did the conversion in 2010.
The cardinal rule of Roth IRA conversions is to make sure you have money outside your IRA to pay the tax bill – borrowing from your IRA will not only lessen the amount of money available to grow tax-free, but you’ll also be subject to a 10 percent early withdrawal penalty if you’re under age 59 ½.
So what about that er’s remorse? There are several reasons someone might want to recharacterize their converted Roth IRA:
You decide you can’t afford to pay the additional taxes owed after all – perhaps you become unemployed for a few months or other pressing expenses arise.
Adding income from the conversion puts you into a higher marginal tax bracket or subjects you to the alternative minimum tax.
The value of your converted Roth IRA has dropped significantly, so in effect you’re paying taxes on phantom money.
There are a few rules to keep in mind if you decide to recharacterize:
You have until October 15 of the year following the conversion to recharacterize, provided you’ve filed your tax return – or filed for an extension – on time.
You can recharacterize all or part of the converted amount.
The amount you recharacterize will be adjusted for any gains or losses while it was invested in the Roth IRA.
To initiate a recharacterization, contact the financial institution that has your Roth IRA for instructions.
You’ll need to file an amended tax return (IRS Form 1040X) along with IRS Form 8606.
You can later reconvert the recharacterized IRA back to a Roth, but you must wait until 30 days after the recharacterization or one year after the initial conversion, whichever is later.
Clearly, these are complicated transactions, so it’s probably a good idea to work with a tax professional or financial planner to guide you through the process. If you don’t have financial planner, the Financial Planning Association (www.fpanet.org) is a good place to search.
Jason Alderman directs Visa’s financial education programs. To Follow Jason Alderman on Twitter: www.twitter.com/PracticalMoney