Oops! So you screwed up your Roth IRA conversion. Hey, you're young; it happens. Besides, the IRS has an app for that – at least a rule – when it comes to a Roth conversion or an ineligible Roth contribution. You simply rewrite the past by recharacterizing the conversion or contribution. You don't even have to give the IRS a reason for the recharacterization, and you can wait until you see your tax bill before deciding whether to revisit the conversion or contribution.
If you make an ineligible Roth contribution, you'll get nailed with an annual 6 percent tax penalty forever – or until you move the money. There are three primary reason to revisit a conversion from a traditional IRA, starting with this basic premise: The conversion will be taxed as ordinary income on the day of the transaction. If your portfolio dipped, your tax bill will be figured on more than the assets are worth now. You also could discover that the conversion income will push you into a higher tax bracket, or that you simply don't have the money to pay the tax bill for the conversion.
A conversion must be completed by Dec. 31 of the tax year. A Roth contribution must be deposited by the April tax-filing deadline. Your recharacterization deadline is your tax-filing deadline – April 15 most years – but if you file for an extension, you'll have until Oct. 15 to complete the recharacterization.
Easy Does It
If your contribution or conversion was made into a new Roth IRA with no other assets, you can undo the entire conversion simply by sending the whole pile to a traditional IRA. The 1099-R you receive for the conversion will be superseded by a Form 5498 from your Roth custodian covering the recharacterization.
Mixed Assets Recharacterization
Putting your contribution or conversion into an existing Roth IRA makes the recharacterization more complex. The IRS requires you to account for investment performance in calculating the recharacterization amount, and it must be based on the returns of the entire account, not just the converted amount or the assets purchased with the contribution. Example: You convert $15,000 in IRA assets into a Roth that already has $30,000. The market tanks. Your converted assets fall by 20 percent and your previous assets by 10 percent, reducing your account balance to $39,000 – an overall drop of 13.3 percent. To recharacterize your converted $15,000, you must return $15K minus 13.3 percent –$13,000 – to your traditional IRA. But your converted assets are now worth only $12,000, so you must also move $1,000 of the original Roth assets as well. Eventually, of course, you'll have to pay tax on that extra $1,000 again, either when you reconvert it or when you take a distribution from your IRA.
You also can choose to recharacterize only part – let's say half – of your conversion or ineligible contribution. You again must account for investment returns. If the conversion was made to a new Roth account, you simply recharacterize half the assets. If the recharacterization comes from a blended account, you must factor in the returns of the entire account. Report your partial recharacterizations on IRS Form 8606.
You must wait 30 days for a new conversion from the IRA that received the recharacterized assets. Plus, you're not allowed a conversion from that IRA account in the same year as your original conversion. If you open a new account to house the recharacterization, that's the account subject to the holding periods. The IRS lets you convert assets from another traditional IRA immediately, even from the account from which you made the conversion you recharacterized.