What is a Roth "Recharacterization" And How do I use it?

When my three boys where younger, there were lots of battles. I know what you’re thinking: lots of fights and all kinds of physical stuff. Not really. Their fights were more intellectual, including one argument over an imaginary piece of paper. I’m still trying to figure that one out. Nevertheless, after each argument, strangely, each would characterize the events differently. In a way, they were recharacterizing what happened, so they could have the pleasure of seeing the other one punished!

For you, recharacterization should conjure up an image of something that could be quite beneficial. Essentially, the Internal Revenue Service (IRS) grants you a do-over if, after completing a Roth conversion, you want to take it back.

A Roth conversion occurs when you convert funds from a traditional IRA to a Roth account. Conversion does NOT come without a price. When you do it, you are removing money from a tax-deferred account, so you will pay some income tax.

After converting the funds, some people have second thoughts - much like my wife probably did after we exchanged wedding vows. In your case, the remorse might stem from any of the following reasons.

1) Value of your investments decline in the converted Roth IRA.

2) Taxable income is much higher than you expected and/or additional income from the Roth IRA conversion bumps you into a higher tax bracket.

3) Taxable income in retirement will likely be lower than expected, reducing the potential benefits of a Roth IRA’s tax-free distributions. (By the way, this is a myth, and I find that this lower tax bracket nonsense is rarely the case. Most retirees end up in the same or a higher bracket in retirement.)

Wanting to recharacterize because of a decline in investment value is common, so let’s examine that one.

Let’s say you convert $50,000 and your tax rate for the conversion is 25%. You would pay $12,500 in tax. (A bitter pill to swallow, but you’re going to pay the tax eventually!) Assume the converted amount is invested and doing nicely at the time you make that election. Shortly thereafter, the market drops 20%, and your stock fund takes a big hit. Now, the $50,000 is worth $40,000, and you have paid an extra $2,500 in tax. (A drop of $10,000 x 25%). Now, you’re steaming mad because you know that paying too much tax is not a good wealth accumulation strategy!

Fortunately, the IRS allows some relief when this occurs:

A recharacterization allows you to “undo” or “reverse” a rollover or conversion to a Roth IRA. You generally tell the trustee of the financial institution holding your Roth IRA to transfer the amount to a traditional IRA, effectively ignoring the Roth IRA contribution.

Generally, you can recharacterize your rollover or conversion by October 15th of the following year, regardless of whether or not you requested an extension to file your tax return. For example, for your conversion to a Roth IRA in 2016, you have until Oct. 15, 2017, to recharacterize.

Many people like to have some fun with this by trying to pay the lowest tax possible. Then, they ask: When can we convert again?

If you recharacterize all or part of a rollover or conversion to a Roth IRA, you cannot reconvert the amount recharacterized to the same or another Roth IRA until:

1) 30 days after the recharacterization, or

2) Year following the year of the rollover or conversion

Sounds like great fun! Whatever you do, keep good records on what you’re doing. It’s easy to get tripped up, and you don’t need any hassles if the IRS comes calling.

That’s just the way it works!