Wednesday, October 5, 2011

Is A Roth Recharacterization Right For You?

In 2010, many people took advantage of law changes enabling them to convert their traditional retirement accounts to a Roth IRA. The intention was to pay taxes on those retirement dollars in 2010 and enjoy tax-free growth going forward.

While this is likely still a sound strategy, the recent market downturn may provide a less expensive opportunity to do this. Consider the example of an individual in the 25% Federal tax bracket who converted $100,000 of retirement funds to a Roth IRA in 2010. In doing so, this investor paid $25,000 in taxes so that all future earnings in the Roth account would grow tax-free.

Now suppose this investor’s current account value has dropped to $80,000 during the volatile market we’ve experienced. An investor might argue that it was unfair to pay taxes on $100,000 of income when the asset is now only worth $80,000. Believe it or not, the IRS is willing to agree.

By recharacterizing the 2010 Roth conversion, both the investor and the IRS can pretend that the 2010 Roth conversion never took place. Essentially, the investor is converting the Roth dollars back into a traditional IRA account where taxes are again deferred and it’s like the Roth conversion never happened. This eliminates the tax bill that was created by the original Roth conversion.

As most people have already filed their 2010 tax returns, they will need to file an amended 2010 return in order to eliminate the reference to the Roth conversion and receive a refund of any unnecessary taxes paid.

What if the investor still prefers the tax-free treatment a Roth IRA provides? Amazingly, the IRS provides an opportunity to still take advantage of these great investment vehicles. After 30 days have passed since the individual recharacterizes his Roth account back to a Traditional IRA account, the investor can against convert the funds back to Roth dollars. What is the advantage of this? Now the investor is paying taxes on $80,000 of income rather than $100,000. Assuming the taxpayer is still in the 25% Federal bracket, the tax bill would now be $20,000. Thus, by recharacterizing and re-converting, the individual lowered their tax bill by $5,000!

The small hassle of this process may not be worth it if the tax savings will only be a couple hundred dollars. However, if you’re due to lower your cost by thousands of dollars, it is definitely something you should look into.

If you converted retirement funds to a Roth IRA last year, speak to your financial advisor to determine if you might be able to reclaim any unnecessary taxes you have paid. Notice: applications for Roth recharacterizations are due October 17th.


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Financial Manager said...

In my opinion, the Roth IRA is suitable for a very specific demo. Most people will be better off using a traditional retirement account that provides tax deferment. The growth on the compounding interest is more likely to benefit them over the long run. Additionally, they will most likely be in a lower tax bracket when they start taking distributions.

Financial planners orlando said...

Financial planners can help a great deal in choosing profitable investment projects for their clients. Investors also need to pass on complete information regarding their current financial status to their financial planners.

Ginny Crandall said...

This is extremely interesting to me. My husband and I have a Roth 401K, and we are using it as much as we can, despite the fact that we are both in our 20s. I am wondering how this would affect my parents, though. I think I need to have them talk to a financial planner in order to get this all sorted out. Thanks for the tax tip, though!