Time's Running Out for a Roth IRA "Do Over"

Q: My retirement account has declined in value since I converted from an IRA to a Roth IRA earlier this year. Do I still have to pay the taxes on the full amount?

A: This year, when the government eliminated the income ceiling barrier to Roth IRA conversions, many taxpayers converted their traditional IRAs to Roth IRAs. The primary appeal to the strategy is that withdrawals from the Roth will be tax-free and penalty-free after age 59 1/2. The main stumbling block is that those who switch will have to pay income taxes on the assets that came out of the traditional IRA.

If you opted to convert your IRA to a Roth, you may indeed be facing a hefty tax bill -- even if you choose to split the income from the conversion between your 2010 and 2011 returns, as the Internal Revenue Service allows you to do. Even worse, the tax on the conversion may land you in a higher tax bracket, increasing the tax pain. Worst of all, many taxpayers such as yourself are also facing the prospect of paying income tax on funds that are worth less than they were when they converted.

If you’re having second thoughts about the wisdom of the conversion, you still have time to take it back. According to a recent survey by Fidelity Investments, less than a third of investors who became eligible to convert to a Roth this year know that they can switch back if they choose to -- but the deadline for doing this is fast approaching. Under the rules, you can undo the Roth conversion, a process known as “recharacterization,” up until Oct. 15. You can choose to recharacterize all of the assets you converted to a Roth, or just a portion of the funds.

If your Roth account has gone down in value since you converted the funds, but you still want to keep your retirement funds in a Roth, you can also use recharacterization to lower your tax bill. Here’s how it works: You must recharacterize your Roth before the Oct. 15 deadline and move your reduced assets back into an IRA. Then, after 30 days has elapsed, go ahead and reconvert your IRA back into a Roth. Because the amount of the assets converted will be lower the second time around, your tax liability will also be reduced.

For an overview of how recharacterizations work, check out tax-information website Fairmark.com. As with any tax-related moves, however, it’s always best to check with your accountant or tax professional before taking action.