Converting money from a traditional IRA to a Roth IRA helps many taxpayers lock in low tax rates at auspicious times and enjoy unlimited tax-free growth for decades into the future. Yet an arguably even bigger benefit from a Roth conversion is that you can get a do-over if it doesn't go as well as you had hoped. By using Roth IRA recharacterization, you can undo a previous Roth IRA conversion if it makes sense to do so. In some cases, that can help you save a huge amount in taxes. However, the clock is ticking on recharacterizing Roth conversions from the 2016 tax year, and you only have a few days left to take advantage of the strategy.
Why would you want to recharacterize your Roth?
Having gone to so much trouble to do a Roth conversion, you might wonder when you'd ever want to undo all that hard work through a recharacterization. There are several situations in which recharacterizing your Roth conversion makes sense.
The most common reason to recharacterize is that the investments you made in your converted Roth have gone down in value. The benefit of a Roth conversion comes from the fact that you don't have to pay taxes on subsequent growth in the retirement account. If your account value falls, then you get no tax benefit. Moreover, because you have to include the value of the Roth at the time of conversion in your taxable income, a decline in value of the Roth means that you're paying more in taxes than you have to. It's almost always smarter to recharacterize, because by doing so, you can avoid having to pay tax on money that you've subsequently lost. Later on, you can consider converting again, with future taxes based on the smaller amount that reflects your losses. That can save you thousands in unnecessary tax on a conversion.
Another problem that sometimes comes up is that taxpayers don't have enough cash on hand to pay the tax on their Roth conversion. It's best to plan for the taxes due before you convert, but many taxpayers don't get around to that until it's too late. Using the converted assets to pay the tax is almost always the worst solution, because not only do you lose the potential future tax benefits on that money, you'll often have to pay both taxes and penalties on the amount that goes toward your tax bill. Recharacterizing the conversion to avoid the tax hit entirely is sometimes the best option.
Finally, if you converted early in the tax year, it's entirely possible that your tax situation didn't work out the way you expected it would. The elimination of income limits on Roth conversions means that you'll never have to recharacterize in order to avoid violating the tax laws. But if you ended up being in a higher tax bracket during the year you converted than you expected, then your eventual tax bill could be higher than you initially projected. Recharacterizing allows you to undo that decision and perhaps wait until a future year in which your tax situation is more favorable for a conversion. That's especially timely right now, because uncertainty about the fate and timing of major tax reform has made it difficult to do reliable tax planning.
Why you need to act now
The reason for urgency is that there's only so much time that you have to recharacterize a Roth conversion. The time limit for recharacterizing is the due date, including extensions, of the tax return for the year in which you did the conversion. So if you're looking to recharacterize a 2016 Roth conversion, you only have until Oct. 16 to recharacterize. Those who convert in 2017 will have until mid-October 2018 to recharacterize.
Another thing to keep in mind is that recharacterizing creates a waiting period before you can do subsequently do a Roth conversion on the same assets. You have to wait until the subsequent tax year to do a second conversion. Even if you're recharacterizing a 2016 tax year Roth conversion, you'll still have to wait 30 days before doing another conversion.
Roth conversions are a smart strategy to use, but they don't always work out. Recharacterizing gives you a great option to ensure you get the best result possible from a Roth.