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Roth IRA Recharacterization: The Do-Over That Could Make You Rich

Retirement planning involves complex rules, and you rarely get a second chance if you goof up. But in converting a Roth IRA, the opportunity to recharacterize your conversion essentially gives you a do-over opportunity that you can use to boost your total retirement assets.

In the following video, Dan Caplinger, The Motley Fool's director of investment planning, goes through Roth IRA recharacterizations and how they work. Dan notes that when you convert an IRA, you can later recharacterize it, essentially undoing the entire conversion. That can be especially lucrative if your investments drop in value, as it prevents you from having to pay taxes on a higher amount. But Dan also goes through strategies that let divide your IRA into two parts, retaining the option to recharacterize either part. In his example, by taking high-flying consumer discretionary stocks General Motors (NYSE: GM  ) and Best Buy (NYSE: BBY  ) in one pot and lagging telecoms AT&T (NYSE: T  ) , Windstream (NASDAQ: WIN  ) , and CenturyLink (NYSE: CTL  ) in another, you can choose to keep whichever half outperforms the other while recharacterizing the underperforming portfolio.

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Read/Post Comments (12) | Recommend This Article (30)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 12, 2014, at 1:20 PM, zimmy101b wrote:

    I don't understand. The difference between them is that Roth distributions are tax free. How they are invested and allocated between winners and losers is not as important as knowing that you should take a Roth distribution when you are in a taxable income bracket, the higher the better.

  • Report this Comment On January 12, 2014, at 4:04 PM, amwarner4u wrote:

    Zimmy101b........

    What you said may be true, but this is a conversion and then a recharacterization - no distributions here. For instance Alcoa in my IRA was transferred into a ROTH via conversion. Alcoa goes down in value, then I transfer back to the IRA (recharacterize) so the earlier, higher value of Alcoa is not myr tax basis. Again, there are no distributions on taxes only the conversion and applicable/relative taxes that are considered here.

  • Report this Comment On January 12, 2014, at 4:32 PM, ferdiefor wrote:

    I had a large tax credit Obama and the dems were considering eliminating retroactively to raise revenue back in 09. I found the one best way to use was to do ROTH conversion, step one. I completed doing it in 2011.

    The first asset transferred in 2009: Apple which went on to create enormous spectacular returns in the ROTH.

    My ROTH is worth over double the conversion cost basis. It is a lot more than tax free distributions. You do not have to do mandatory withdrawals so you don't ever have to find out if you could in fact outlive your retirement assets.

    I I can withdraw 4.7% income only leaving principal intact.

    I would encourage today's young people to pass on retirement plans reducing your salary or as a deduction and do ROTH. If your employer offers ROTH 401k: DO IT!

    Do it while you can. Reid and Pelosi hate ROTH because it is their atypical only rich people have ROTH IRAs and it isn't fair. If they could repeal, they would repeal ROTH. I get a certain giddiness when I think about how ticked off Reid and Pelosi must be at people who do the best they can for themselves and their families rather than line up at some government queue for hand outs and giveaways.

  • Report this Comment On January 13, 2014, at 3:05 PM, KevinInOC wrote:

    This strategy seems like an incredible advantage to the investor. Here's my angle on this : If you have a traditional IRA and want to contribute to a Roth, you can open 2, 3, or even 4 separate Roth IRAs, and convert your most risky stocks into these Roths. Chances are that in the next year and a half, each stock will change significantly in value (either positive or negative).

    For the ones that increase, you win - you only pay taxes on the converted amount and the amount of the increase is yours tax free.

    For the ones that decrease, you don't lose - you recharacterize it back into your traditional IRA and you don't pay taxes on your losses, exactly as if you never converted it int the first place.

    Am I missing anything here?

    For example, at the beginning of 2013, I opened three separate Roth IRA accounts. I then transferred about $5000 worth of stocks into each - one stock went up 95%, one went up 70%, and as my fallback I chose gold for my third one, which was down 25%. So I'm recharacterizing the gold, and keeping the remaining two, which are currently worth over $18000, and only paying taxes on $10000.

    I just made 3 more Roth conversions, two risky stocks and gold again (just in case). I almost know for sure I'll be recharacterizing at least one of them!

  • Report this Comment On January 14, 2014, at 1:28 AM, rambarlev wrote:

    How can one open 3 separate ROTH IRA account with the sums mentioned? I understand that you can fund only one ROTH for $5,000 upto $ 6,500,

  • Report this Comment On January 14, 2014, at 3:03 AM, taloft wrote:

    Magic,lol.

    I'm guessing that converting a traditional IRA into a Roth IRA is treated as a roll over. Contribution limits don't apply to roll overs.

    I rolled over my 401K from my last employer into a Roth IRA and was still able to contribute the full amount for the year.

  • Report this Comment On January 14, 2014, at 8:54 AM, deckdawg wrote:

    I've heard this mentioned before, but the light came on as I listened to the short video. I would like to find a more detailed description of the nuts & bolts of actually doing this. There are likely some pitfalls, deadlines to consider, etc. One question would be "When must you pay the taxes on the conversion?". Another would be "Is there any limit on the number of accounts which can be opened?". I had planned on doing some conversion each year after I retire anyway. Would the rules allow me to open, say, 10 accounts with one stock in each account? At the end of the allowed time, move the losers back to the IRA, and pay the taxes out of the winners? Almost sounds too good to be true.

  • Report this Comment On January 14, 2014, at 3:38 PM, KevinInOC wrote:

    Yes taloft - I should have been more clear - it is a rollover from a traditional IRA to a Roth IRA. I actually don't know if there is a limit to the amount that can be rolled over - I've searched and can't find that anywhere. But some references give examples of rolling over an entire traditional IRA worth $100K into a Roth IRA, so if there is a limit, it is very high (I wouldn't want to pay federal and California taxes on a $100K rollover in a single year!)

  • Report this Comment On January 14, 2014, at 3:52 PM, KevinInOC wrote:

    deckdawg - That is exactly the same boat I am in (except that I'm doing my yearly conversions before I retire). I have my traditional IRA with Fidelity, and am able to do everything (except recharacterization) online.

    To try to answer your questions (again, I am far from being an expert on this and am learning on the fly, but I have had a few lengthy discussions with expert representatives from Fidelity):

    You must pay taxes on the conversion when they are normally due. For example, for the two 2013 Roth IRA conversions that I am keeping, I will have to pay taxes on the $10K conversion amount by April 15, 2014 (I'm not filing for an extension). When I did the conversion, I had the option of having taxes withheld, but I chose not to (I always overpay my taxes anyway, so I knew I wouldn't owe any penalties)

    There doesn't seem to be any limit on the number of accounts that can be opened. I did four this year, but I don't see why you couldn't do 10 and increase your chances of a few of them greatly increasing in value. The one thing you want to do to make things much easier is to open separate Roth accounts so that you will either keep the entire converted account and pay taxes on it, or recharacterize the entire account. It appears to be a bookkeeping nightmare if you partially recharacterize a single account that has multiple stocks in it.

    And you sum it up quite well - it does sound too good to be true, being able to recharacterize the losers and keep the winners. But everything I've researched so far says that is indeed the case. I keep waiting to find that one tidbit of information that spoils it all, but so far I haven't found it...

  • Report this Comment On January 14, 2014, at 4:06 PM, deckdawg wrote:

    Kevin, thanks for the feedback. Glad to hear you have the option to not have taxes withheld. My thought would be to open some number of accounts in January, each one containing one of my best stock ideas for the year. Perhaps 5 accounts, each with $20K. Sometime before April 15 of the following year, recharacterize the 3 or 4 that didn't do as well as hoped, only paying tax on the one you keep. If you had to pay all the tax as estimated tax up front, that would be a fair amount of money in the governement's hands until you could get it back later. (I think you have to wait a year to recharacterize). I have found some white papers on this, but really need to find details. Perhaps a visit to a CPA would be worth the money.

  • Report this Comment On January 14, 2014, at 5:33 PM, nancysioux wrote:

    For basic information, check out form 8606 and the instructions on www.irs.gov; it explains how this works fairly well, along with examples. Also Publication 590 on IRS conversions and reconversions is very helpful. go the the forms and publications on line to view this stuff.

  • Report this Comment On January 20, 2014, at 9:39 PM, piasabird wrote:

    You can pay taxes now or later. Since it is a good chance that taxes will go up and it is going up for people in higher tax brackets, then it might be better to not pay taxes now. Tax rates sometimes change. ACA could be defeated shortly. We dont really know what the future will bring. Remember those that voted for ACA and get rid of all of them.

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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