Investor Education | How to undo a Roth conversion
In the financial world, you are usually not allowed to undo a transaction. You made your decision, and now you have to live with it, for better or worse. But there is a notable exception for retirement-savers. If it suits your purposes, you can “recharacterize” a Roth IRA conversion.
In other words, if you converted funds in a traditional IRA to a Roth last year, you can reverse the conversion as if nothing happened, no questions asked. And you have until the extended deadline for filing your 2014 tax return—October 15, 2015—to undo a 2014 conversion.
Background: The annual contribution limit for traditional and Roth IRAs is the same. For 2015, the limit is $5,500 per person, or $6,500 if you are age 50 or older. (This is also the limit for any combination of traditional and Roth contributions for the year.) Although traditional IRA contributions may be partially or wholly tax-deductible, distributions are generally taxed at ordinary income-tax rates. Conversely, you can never deduct contributions to a Roth, but qualified distributions, such as those made at age 59½, are completely tax free five years after setting up the account. Plus, you don’t have to take mandatory lifetime distributions after age 70½ as with a traditional IRA.
When you convert to a Roth, the value of the funds transferred to your new account is taxed just like a regular distribution from a traditional IRA. Therefore, if you convert some funds in 2015, the tax is due on a 2015 return, but you are in line for future tax-free benefits.
However, there is a time and a place for a recharacterization. Here are a few common examples.
- The value of the funds has declined since the conversion, so you have effectively overpaid the tax liability.
- The amount of the conversion tax caught you by surprise and you cannot afford to pay the IRS.
- You simply decide that the Roth conversion is not the best approach for your situation.
If any of these is the case, you can choose to recharacterize the Roth back into a traditional IRA by the tax return due date for the year of the conversion, plus extensions (i.e., October 15, 2015, for a conversion in 2014). This should give you enough time to figure out the best course of action.
Furthermore, you can reconvert back to a Roth, if that suits your needs, after some time has passed. The earliest date allowed for a reconversion is either the later of the beginning of the tax year following the tax year of the conversion, or the end of the 30-day period beginning on the day of the recharacterization.
In summary: The rules for recharacterizations and reconversions provide flexibility for retirement-savers. Consult a professional adviser for guidance.
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Investment Consultant
Tam Hubert, CFP®, CFA
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Kristi Remus
