Press Room: Tax Release

August 15, 2011

Undoing An Earlier Roth Conversion and Reconverting May Result In Tax Savings

In light of the current market changes, some taxpayers may have seen the value of their recently converted Roth IRAs decrease. This situation may create the opportunity for considerable tax savings if quick action is taken. Tax due on a Roth IRA conversion is determined by the value of the account on the date of conversion. A taxpayer may wish to undo a conversion made in 2010 or earlier in 2011 if the current value of the account has decreased substantially since conversion.

Roth IRA owners can essentially unwind a Roth conversion made in 2010 or 2011 through the process of “recharacterization.” Recharacterization averts the taxable income inclusion associated with the original conversion. The taxpayer can then "reconvert" the account back into a Roth IRA, resulting in less taxable income due to a potentially lower account value.

If you converted a traditional IRA to a Roth IRA in 2010 you generally have until October 17, 2011 to elect to undo the conversion. Under a special automatic election rule, this election can be made even if you already filed your return on a timely basis. If you converted a traditional IRA to a Roth IRA in 2011, you can undo that conversion any time up through October 15, 2012.

If you recharacterize a 2010 conversion, you can make another conversion to a Roth IRA after 30 days. However, if your conversion occurred in 2011, you have to wait until the later of 30 days after the recharacterization or January 1, 2012.

The taxable income from a 2010 conversion was permitted to be deferred, with half recognized in 2011 and the other half in 2012. If you recharacterize a Roth and reconvert after 30 days, the total value of the reconversion will be taxable in the year in which it is made, with no deferral or spreading of the income.

Example: You converted $1 million in a traditional IRA to a Roth IRA in 2010. You filed your income tax return on April 15, 2011 (no extension). Since $500,000 is reported as income in 2011 and 2012, no amounts were included on your 2010 income tax return. On August 15, 2010, the Roth IRA has a value of only $850,000. You elect to recharacterize the 2010 conversion as a rollover to a traditional IRA. As a result, you do not have to include $500,000 in income in 2011 and 2012. On September 20, 2011, the traditional IRA is valued at $925,000 and you make a new conversion to a Roth IRA. For 2011, you will have to include $925,000 in income as a result of the 2011 conversion. You have saved income taxes on $75,000, but the entire $925,000 must be paid with the 2011 tax return.

To effectuate the recharacterization of a 2010 Roth conversion, the following must happen on or before October 17, 2011:

  1. you must notify the Roth IRA trustee of your intent to recharacterize, providing them with information that they need to implement the transfer back to a traditional IRA;
  2. the trustee must make the transfer; and
  3. if you have already filed your income tax return for 2010 you must file an amended return properly reflecting the effect of the recharacterization.

WTAS professionals can assist you to evaluate the potential benefits and risks of a Roth IRA recharacterization and reconversion. Please contact your WTAS advisor to learn more.