As a result of the recent downturn in the securities market, many individuals have seen their portfolios devalued significantly over the last year. For individuals who converted amounts from an IRA to a Roth IRA in 2010, this is even more disconcerting because they may now owe taxes on amounts they no longer have in their retirement accounts. The good news is if you converted to a Roth IRA in 2010 and your account has become devalued you have until October 17, 2011 to undo the conversion.
If the investments in your new Roth IRA lose value after the conversion, you’ll have an adverse tax outcome, because the taxable distribution from the conversion will still be based on the value of the account on the conversion date. In other words, you’ll wind up owing taxes on money you no longer have. Let’s say the value of the Roth IRA drops from the initial conversion value of $50,000 to $35,000. You’ll still have a $50,000 taxable distribution from the conversion (assuming you have no tax basis), even though the Roth account is now worth only $35,000.
Fortunately, you can avoid this unfavorable outcome by reversing the Roth account back to traditional IRA status. The IRS calls this process “recharacterizing” the account. Once the recharacterization is complete, you’re right back where you started, tax-wise—though your IRA is now worth $35,000 instead of $50,000. To summarize: the conversion is reversed, the $50,000 taxable distribution disappears, (along with the related tax liability), and the account is again a traditional IRA, now worth $35,000.
If you have a 2011 Roth conversion that you want to recharacterize, you have another year – until October 17, 2012 – to do so.
Whether it makes sense to recharacterize your Roth conversion depends on several factors, including the extent of the losses in your Roth IRA, the potential value of the special 2010 tax deferral rule to you, and your expectations of where the markets may be headed. Your William Vaughan Company professional can help you decide if a recharacterization is right for you.
