Mutual fund investors who converted to a Roth IRA last year but now regret it have until Oct. 15 to reverse the move and get back any taxes they paid under a little known IRS rule.
Roth IRAs have some benefits over traditional IRAs, but they are not for everyone. If your financial circumstances have changed – or if the value of your Roth IRA has declined substantially– it may benefit you to undo your Roth conversion.
The key point about a Roth IRA conversion is that you pay taxes up front on the amount you convert. That amount is added to your taxable income for the year. But what if you unexpectedly find yourself in a higher tax bracket the year you convert? You may be better off going back to a traditional IRA, where you will pay taxes in retirement as you withdraw funds.
Alternatively, you may discover that your retirement income will be lower than expected, once again leaving you better off paying taxes after you retire than paying them now.
A third reason to regret a conversion is if the value of your new Roth declines significantly. Here you have paid taxes on, say, an original $100,000 conversion but now find your Roth IRA to be worth just $75,000. The smart move would be to undo the Roth conversion, get back the taxes you paid, and then redo the conversion later, paying taxes only on the lesser amount. You can reconvert to a Roth 30 days after recharacterization or in the next tax year, whatever comes later.
The ability to recharacterize also comes in handy when you find you don’t have enough money to pay the tax on the conversion.
You also can use recharacterization as an investment strategy. Fidelity Investments has an informative article on the ins and outs of recharacterizing Roth conversions.
IRA contributions may also be recharacterized as Roth IRA contributions by the deadline.
The rules can be complicated so you should consult with your tax adviser about whether a recharacterization is right for you and how you can use it to benefit you the most.
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