For those who feel they made a mistake by converting to a Roth IRA, the deadline to execute a “recharacterization” back to a traditional IRA is fast approaching. The deadline is set for Oct. 15, the same deadline for taxpayers who were granted an extension to file. Since the paperwork might take a few days and is requested from the account holder’s financial institution, it’s best to start sooner rather than later, experts say.
IRS rules dictate a conversion from a traditional IRA to a Roth can be made without penalty within a given year, although any appreciated gains within the account are included as income and taxed at that time.
Once the conversion is made, the account holder may experience an unforeseen change in circumstances that necessitates a change back to the traditional IRA; for instance, a spike in income that might put them in a higher tax bracket.
Additionally, after 30 days the IRS then allows for another conversion to a Roth IRA if the account holder so chooses.
So why would an investor put themselves through such back-and-forth rigmarole? The answer is to change the fiscal year in which the conversation is effective, thereby taking advantage of lower tax rates and other benefits unique to their situation.
“The primary factor that motivated conversions to Roth IRAs in recent years has been the prospect of higher ordinary income tax rates in 2013,” adds Robert Bloink, a professor of tax at Thomas Jefferson School of Law and an AdvisorOne contributor. “Funds contributed to a traditional IRA are contributed pre-tax today, but are taxed at ordinary income rates when they are eventually withdrawn. Conversely, funds contributed to a Roth are taxed today and withdrawn tax-free.”
Bloink notes that if a client’s Roth IRA performed poorly since it was converted, it might not be worth the taxes that the client continues to owe in 2012, even though the value of the account decreased.
“While converting to a Roth in 2012 remains a smart move for many clients, advisors should examine the results of any conversion because of the uncertainty accompanying that initial conversion,” Bloink concludes. “The option of undoing the conversion and trying again for next year is a valuable part of the Roth conversion strategy and could save your clients thousands in taxes.”