Converting a traditional IRA to a Roth IRA can provide tax-free growth and the ability to withdraw funds tax-free in retirement. However, what if you convert a traditional IRA — subject to income taxes on all earnings and deductible contributions — and then discover that you would have been better off if you had not converted it? Fortunately, it is possible to undo a Roth IRA conversion, using a “recharacterization.”

Reasons to Recharacterize

There are several possible reasons to undo a Roth IRA conversion. For example:

• You lack sufficient liquid funds to pay the tax liability;
• The conversion, combined with your other income, has pushed you into a higher tax bracket;
• Your income is likely to drop in retirement, reducing or eliminating the benefits of a Roth IRA; and
• The value of your account has declined since the conversion, which means you would owe taxes partially on money you no longer have.

Generally, when you convert to a Roth IRA, you have until October 15 of the following year (if you extend your tax return) to undo it. Then, you must wait to once again convert to a Roth IRA until the later of: 1) The first day of the year following the year of the original conversion, or 2) the 31st day after the recharacterization.

Keep in mind that, if you reversed a conversion because your IRA’s value declined, there is a risk that your investments will bounce back during the waiting period. This could cause you to reconvert at a higher tax cost.

Recharacterization in Action

The following example illustrates the process. Nick has a traditional IRA with a balance of $100,000. In December 2016, he converts it to a Roth IRA and normally would owe $33,000 in federal income taxes in April 2017. However, Nick extends his return and, by September 2017, the value of his account has dropped to $80,000.

On October 1, Nick recharacterizes the account back to a traditional IRA and files his return to exclude the $100,000 in income. On November 1, he reconverts the traditional IRA, whose value remains at $80,000, to a Roth IRA, and reports that amount as income on his 2017 tax return. This time, he owes only $26,400 in taxes.— Nick deferred the tax liability for a year and also saved $6,600.

Keep Your Options Open

If you convert a traditional IRA to a Roth IRA, monitor your financial situation. If the advantages of a Roth IRA diminish, talk to your financial advisor about your options.

For more information, contact Peggy Vyborny at [email protected], or call her at 312.670.7444. Visit ORBA.com to learn more about our Wealth Management Services.