You Can Unconvert Your Ira-to-roth Conversion To Offset Investment Loss

The taxation that accompanies converting your traditional IRA to a Roth IRA can be substantial

. Presumably, you determined that you'll eventually gain more benefits from making the conversion to a Roth than keeping that money in your traditional IRA. However, if those converted funds 'go south' in value as the market falls, you can 'unconvert' your Roth to recover the conversion tax you paid. Here's how it works...

Suppose you converted $100,000 of your traditional IRA to a Roth IRA. Then, due to a market downturn, your converted funds in your new Roth lose a significant amount of value. Perhaps they're now worth only $50,000. It's tough to take the fund's loss, and especially so, since you had to pay income tax rates on the $100,000 worth that you converted.

*A chance to recover losses - somewhat:

You can't do anything about the market loss, but you can do something about that conversion tax on that $100,000. Remember, that conversion tax is treated as income tax on the value you converted. That can be a substantial amount of tax since it comes in at the income tax rates.

If you 'unconvert' that transfer soon enough, you're back holding a traditional IRA - perhaps with only $50,000 value - but then you're no longer liable for the income tax on the $100,000 conversion you made. If you still think converting to a Roth is still a good idea, you can redo the conversion a year later but then pay income tax on the conversion of the $50,000 rather than the $100,000. So this 'reconversion' tactic can save you some money if your converted investment goes south fast.

*The rules for 'unconversion' which the IRS calls 'recharacterization:

If you convert to a Roth IRA one year and then decide to 'unconvert' it, you must do what is called 'recharacterize' by the IRS by the extended due date of your tax return for the year of conversion. (Recharacterizing your conversion means unconverting) This would normally be April 15 following the year of conversion, or as late as October 15, if you have filed for and obtained an extension.

You, also, may not make a Roth conversion, then "unconvert" it and then reconvert the same IRA money in the same year. If you wait to 'unconvert' the Roth the next year, you must still wait 30 days after the 'uncoversion' is completed before reconverting back to a Roth IRA.

Be sure to notify the trustees of both IRAs - the original traditional IRA and your converted Roth IRA - before the transfer date that you want to "unconvert" (i.e. recharacterize) that Roth IRA as a traditional IRA. Let them know:

- the amount of the conversion to the Roth IRA to be recharacterized, all or some fraction of it;

- the date you made the conversion and the tax year for which it was made;

- any additional information needed to make the transfer, including the names of the trustees involved1

You must also report the recharacterization on the tax return for the tax year in which you made the original Roth conversion. Recharacterization, once completed, is irrevocable.

*Is the 'recharacterization' worth doing in your case?

I presume that you originally felt it to be worthwhile to convert your IRA to a Roth for the benefits you expected from owing a Roth. If that's the case, you need to see if recharacterization of your Traditional IRA-to-Roth conversion is worthwhile in your case only if your converted Roth funds dropped significantly.

If so, simply compare how much your converted Roth dropped in value to how much conversion tax you paid - or are still obligated to pay. If it's sufficient to unconvert in your case, then do so and recover all that you paid for the conversion tax. Remember you can reconvert back into a Roth relatively soon, and then only have to pay the 'new' conversion tax - for the 'unfortunately' lower value of your funds.

by: Shane Flait

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