This is the second article in a multi-part series dealing with the topic of converting a traditional IRA to a Roth IRA. For other articles, see:
Part 1 – Reasons to Consider the Roth Conversion
Part 3 – The Impact of Income Tax Rates
Part 4 – How Long Can You Stretch?
Part 5 – The Impact of Investment Returns During the First 21 Months
Part 6 – The Impact of Estate Taxes
Part 7 – Ramifications of Charitable Giving
Part 8 – Putting It All Together
This article will focus on recharacterizations. A recharacterization allows you to change your mind and undue a Roth conversion. This is such a valuable option, that it will significantly influence how many people choose to make a conversion.
A recharacterization can be made any time before October 16 of the calendar year following the conversion. This means that if you make the Roth conversion in January of 2010, you can recharacterize as late as October 15, 2011. You have nothing to lose by making the conversion in 2010. You can make the conversion, evaluate the consequences for up to 21 months, and then recharacterize if you decide that the conversion was a bad idea.
A decline in the value of the Roth IRA after the conversion will be a common reason for making a recharacterization. Alternatively, you might decide that you cannot afford to pay the tax from separate assets or that you or your children will be in a lower tax bracket in the future.
If you recharacterize, you must recharacterize the entire Roth IRA account. However, you do not have to recharacterize all Roth IRA accounts. If you segregate your IRA into multiple Roth IRAs at the time of the conversion, you will be able to pick and choose which accounts you recharacterize. If one or more of the accounts goes down in value, you may be well advised to recharacterize the accounts that have declined in value. You should work with your investment advisors to fund the various accounts with different assets whose historical returns have not been highly correlated.
If you only plan to convert a portion of your IRA, you might as well convert the entire account and create several Roth IRAs. You can then recharacterize the accounts that have the lowest investment return.
After you recharacterize, you can reconvert to a Roth IRA again. The reconversion can be made on the later of (a) 30 days after the recharacterization; or (b) the taxable year following the taxable year of the original conversion. For example, if you convert in January of 2010 and recharacterize on November 1, 2010, you will have to wait until January 1, 2011 before you can reconvert. If you recharacterize a January 2010 conversion on October 15, 2011, you will be able to reconvert on November 15, 2011.
Because the deadline for recharacterizing is October 15 of the year following the year of the conversion, there is an advantage to making a conversion in the early portion of the year. If you convert in December, you will have 10 months to decide whether or not to recharacterize. If you convert in January, you will have as much as 21 months to evaluate the decision.
In summary, the ability to recharacterize a Roth IRA conversion will cause numerous individuals to “test the waters” even if they are not convinced that the conversion is a good idea for them. When you convert your traditional IRA to a Roth IRA, you should consider splitting the IRA into several Roth IRAs so that you can maximize the benefits afforded by the recharacterization option.