The summer slump in the stock market that shaved over 1,000 points off the Dow Jones Industrial Average may have also shaved some of the value from your Roth IRA. If your Roth was created from a Traditional IRA conversion, the value could be below the taxable amount of the conversion. The last thing you want is to pay tax on money you no longer have. In this situation, you may want to consider recharacterizing.
Recharacterizing makes the entire event go away for tax purposes. Let’s say that Tom Andrews converted $100,000 of his IRA to a Roth during the spring this year when the stock market was near the high. Now his Roth is only worth $90,000. He could recharacterize the $90,000 Roth back to a traditional IRA and have no tax implications.
Recharacterizations do not have to be done in the same year as the conversion. You actually have until your filing deadline, including extensions, to complete the transaction. That means conversions done during 2011 have until October 15, 2012 to be recharacterized. While it is important to think about this for year-end tax planning, there is no urgency to get this done.
Once you recharacterize, you cannot convert again until the new tax year or 30 days has past, whichever is longer. That is why it is usually a good idea to wait until the end of the year to recharacterize. Andrews doesn’t want to recharacterize his $90,000 Roth now only to have the market rally and his traditional IRA grows to $110,000 by January when he can move it back to a Roth. Recharacterizations are irrevocable decisions. You can’t reinstate the original conversion.
Recharacterizations are not all or nothing – partial recharacterizations are permitted. Andrews may not be too concerned about the 10% drop in value but he is now in receipt of a $50,000 bonus that he was not expecting when he decided to do the original conversion. He could decide to recharacterize half the amount to avoid moving into a higher tax bracket. You can even pick and choose if you converted IRAs at different times. Andrews could have converted $50,000 in the spring when the market was high and another $50,000 in August when the market was lower. If the market is still down in December, he could decide to recharacterize only the conversion done in the spring.
The risk of recharacterization is two-fold. First, the market can move against you if you are intending to convert back to a Roth while the value is down. This is why we usually wait until December to consider recharacterizing due to market declines. You have to wait a minimum of 30 days. Recharacterizations done on December 1st can be reconverted on January 1st.
The second risk is political. You can only reconvert in a new tax year. Tax law changes could alter your tax bracket, increasing the tax cost of reconverting. This may not be a big concern in 2012, but tax law is scheduled to change in 2013. It seems unlikely that Congress would accelerate tax increases in an election year.
We generally consider recharacterizations in our tax projections during the fourth quarter. It is helpful to know where the breakeven point is for taxes and market value. It is our objective to have a plan in place by December so we know what circumstances would trigger a recharacterization for the client. Start planning now, but don’t be in a hurry to recharacterize; there’s plenty of time.
- Your 401(k) is one of your most important tools to minimizing taxes. Don’t use more than you need.
- Most people spend more time planning their vacation than they do planning for retirement.