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Should you reverse a Roth IRA conversion made in 2010?

by on
in Small Business Tax,Small Business Tax Deduction Strategies

Since the beginning of the year, financial experts have been beating the drums for Roth IRA conversions. And this tax strategy still makes sense for many taxpayers. But you may find, upon closer review, you would be better off if you had left things alone.

Are you completely out of luck? Not necessarily. That tax law provides a fallback position.

Strategy: Recharacterize your Roth IRA. You can convert your Roth back into a traditional IRA if you choose. It’s like it never happened.

The tax law provides a unique benefit for converting to a Roth in 2010, but there are several reasons why you might want to “undo” a conversion made earlier this year. The deadline for recharacterizing is your tax return due date plus extensions. So you have plenty of time—until Oct. 17, 2011—to reverse a 2010 conversion, although you might want to do so sooner.

Here’s the whole story: If you convert a traditional IRA, you’re taxed on the amount transferred to the Roth, just like you would if you had received a taxable distribution. (But there is no 10% penalty for a transfer before age 59½.) The payoff is the expectation of tax-free distributions in the future.

For instance, if you receive a post-age-59½ distribution from a Roth in existence at least five years, the payment is tax-free. What’s more, unlike a traditional IRA, you don’t have to take any required distributions after age 70½, thereby creating an extended tax shelter for your heirs.

Previously, you could not convert a traditional IRA to a Roth in a year in which your modified adjusted gross income (MAGI) exceeded $100,000. But this restriction has been removed, starting this year. And, for a conversion occurring in 2010, the taxable income may be split evenly over the following two years—2011 and 2012. Thus, you might be saving tax as well as deferring it for two years.

If you jumped at this unique opportunity earlier in the year, you can’t be blamed, especially if you were stymied by the $100,000 limit in the past. But now reality may have set in. You may realize that you’ll need more of the funds in the IRA to pay the tax on the conversion. That will dilute much of the tax benefit of the conversion. Or maybe you didn’t figure on the state income tax that will be due on the conversion.

Another possibility: You might not have considered the impact of rising tax rates. If tax rates increase over the next few years as expected, the lure of a 2010 conversion diminishes, even with the tax deferral break.

Currently, the top tax rates of 33% and 35% are scheduled to jump in 2011 to 36% and 39.6%, respectively. A revenue-hungry Congress might boost rates even higher.

Finally, if the value of the assets has declined since the date when you converted to a Roth, you could be facing a higher tax bill than you would have paid on a later conversion (see box below).  

Can you convert back to a Roth again if it suits your needs? Yes, but you can’t “reconvert” a traditional IRA to a Roth before the later of:

  • The beginning of the tax year following the tax year of the conversion, and
  • The end of the 30-day period beginning on the day of the reconversion. This rule applies regardless of whether the reconversion falls into the year of the conversion or the following year.

For example, if you recharacterize a Roth to a traditional IRA on Sept. 1, 2010, you’ll have to wait until Jan. 1, 2011, to reconvert to a Roth. Still, recharacterizing this year may be preferable to waiting until you file your 2010 return.

Finally, be aware that you don’t have to recharacterize the entire amount. You can undo part of the conversion and keep the rest.

Tip: Spreading out conversions over several years may be the optimal approach.

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