If You Regret Converting Your IRA to a Roth, You Can Undo It.

by Sandra Block

Source: USA Today

Sometimes, changing your mind is painful and expensive, which is why you shouldn't get married or buy a house unless you're pretty sure it's the right thing to do.

But when it comes to converting a traditional individual retirement account to a Roth, you can reverse course without spending a dime or breaking anyone's heart. And that's worth keeping in mind as an important deadline for Roth conversions approaches.

Roth IRAs were created in 1997 to encourage more Americans to save for retirement. Contributions to a Roth IRA aren't deductible, but withdrawals are tax-free, as long as you're 59½ or older and have owned the Roth for at least five years.

The 1997 law also allowed investors to convert traditional IRAs to a Roth as long as they paid taxes on any contributions or earnings that hadn't already been taxed. However, Congress imposed income limits that made Roth IRAs off-limits to high-income taxpayers.

The law imposed even stricter limits on Roth conversions. Single or married taxpayers with modified adjusted gross income of more than $100,000 couldn't convert. That restriction has prevented many dual-income couples from converting their traditional IRAs to a Roth.

The income limits on Roth contributions are still in place, but as of Jan. 1, anyone can convert a traditional IRA to a Roth. Many financial firms have been promoting this change as a way to shelter retirement savings from future tax increases. But converting can carry a hefty price tag - and that's where the upcoming deadline comes into play.

If you convert your IRA to a Roth before Dec. 31, you'll have two choices: pay the entire tax bill when you file your 2010 tax return next spring, or divide income from the conversion between 2011 and 2012. After Dec. 31, you'll still be able to convert, but you'll no longer be allowed to spread income from the conversion over two years.

As a general rule, it's a good idea to delay paying taxes as long as possible. And the compromise between the White House and Republican leaders to extend the Bush tax cuts for two years makes the spread-out option even more appealing, says Pamela Villarreal, senior policy analyst for the National Center for Policy Analysis.

If Congress approves the extension, IRA owners won't have to worry about tax rates increasing before they've paid taxes on the conversion, she says. "This sweetens the deal for the conversion if you want to spread it out over two years."

Still, converting isn't appropriate for everyone. It only makes sense if you have money outside your IRA to pay the tax bill, says Stuart Rubinstein, managing director for investment products at TD Ameritrade. Otherwise, you'll have to pay taxes and, for IRA owners under 59½, early-withdrawal penalties on money withdrawn to pay the tax bill. Those costs could outweigh the benefits of the conversion.

Age is also a factor. If you're close to retirement and expect your tax rate to fall when you stop working, you may fare better by keeping your traditional IRA and paying taxes on withdrawals, Rubinstein says.

Unforeseen events could also undo the benefits of converting. You could lose your job, leaving you unable to afford the tax bill. Or the value of your Roth could plummet, forcing you to pay taxes on phantom income, because taxes are based on the value of your account when you convert.

But, as mentioned earlier, the decision to convert isn't irrevocable. If you change your mind, you can "recharacterize" your Roth. A recharacterization turns your Roth back into a traditional IRA and wipes out the tax bill.

The deadline to recharacterize a Roth IRA is the due date of your tax return for the year you made the conversion, including extensions. If you convert before Dec. 31, you'll have until Oct. 15 to recharacterize your Roth as a traditional IRA.

For example, suppose your IRA is valued at $100,000 now but plummets to $50,000 next year. You could recharacterize the Roth before Oct. 15, wait 30 days, and then reconvert the smaller amount to a Roth, resulting in a smaller tax bill. (The IRS requires a minimum holding period of at least 30 days before you can convert back to a Roth.)

There is one caveat, though. If you decide to spread out income from the conversion between 2011 and 2012, you'll miss the Oct. 15 deadline to recharacterize your Roth, says Chris Hobart, a financial planner in Charlotte. That could be a problem if, come April 2012, you discover you don't have money to pay the tax bill.

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