In 2010, we told you that if you have a traditional IRA (no matter your income level), you can convert those funds into a Roth IRA. Many IRA holders went on to convert to a Roth because the principal and appreciation of a Roth IRA grows tax free. But, now with the recent fall in the market, it may make sense to recharacterize or undo your Roth IRA conversion to avoid paying taxes and then to convert it back later.
Example: Spouse’s Roth is in Gain Position & Mine is at a Loss
My wife and I both converted our traditional IRAs to Roth IRAs in December. While her $55,000 conversion account has gained $6,000 so far this year, my $55,000 conversion account has already lost $6,000. Each account had a cost basis of $38,000. Should I recharacterize my Roth IRA by Oct. 17?
Should we recharacterize?
Generally, it’s worth considering whether to recharacterize a Roth IRA when the value of the account has declined significantly. However, that doesn’t seem to be the case in your situation.
What could be the benefits of recharacterizing the account?
The main reason to recharacterize a Roth IRA is for the potential tax savings. In your wife’s case, the account has gained, so it doesn’t fit the scenario. In your case, the account is down about 11 percent. Assuming that your ordinary income tax rate is 33 percent or 38 percent, your tax liability would fall by about $2,000. (The $6,000 loss, multiplied by 33 percent or 38 percent, would total $1,980 or $2,280). However, there are other factors to consider.
What would be the drawbacks?
One key consideration is the timing of tax payments. Because you converted in 2010, you could spread the tax burden over two years. Recharacterizing would eliminate that. So if you recharacterized the account now and then converted back to a Roth IRA 30 days later at the lower account value, the total tax liability for converting to a Roth IRA would be due on your 2011 tax return. By not recharacterizing, you’ll also have an extra $10,000 in cash to hold on to until it’s due in 2012, so think about the interest or investment appreciation you could gain on the $10,000 vs. the tax savings from recharacterizing. By recharacterize now, you won’t owe any taxes, but we’re assuming your intention is to convert back to a Roth IRA as soon as possible.
You also need to keep in mind the cost of amending your tax return. If you’ve already filed your tax return, you’ll need to hire a tax preparer, which can cost several hundred dollars.
What’s my best bet?
Unless you don’t have enough cash flow to pay the tax in 2011 and 2012, you’re better off not recharacterizing, because your tax savings would only be about $1,000 each year.
More Tax Questions? Ask Tax Professionals Online.
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