NEW YORK (MainStreet) — As the stock market continues its volatile ways, now may be the best time to check in on some of those recent retirement planning moves — especially if they concern a Roth conversion.
Investors can undo — or recharacterize — a 2014 Roth conversion, but the second chance does not last forever. Investors need to act before the October 15 deadline.
“You would want to recharacterize if the value of your converted funds declined and you don’t want to pay tax on value that no longer exists,” said nationally recognized IRA expert Ed Slott, founder of Ed Slott & Company and Creator of IRAhelp.com. “You might also want to recharacterize if you simply changed your mind and you decide you don’t want to pay the tax bill.”
Slott said the recent volatility of the market most likely affected balances of funds converted in 2014 when values were higher, prompting some to regret their Roth IRA conversions. However, due to the recharacterization option, that conversion can be undone.
Jamie Hopkins, a professor of retirement at The American College of Financial Services in the Greater Philadelphia area, said the number one reason a person would want to recharacterize their Roth IRA after a conversion is because the value of his investments dropped or because his tax rate in the current or next year is expected to be much lower.
“For instance, if you converted an IRA worth $10,000 when your tax rate was 35% in 2014 and in 2015 you only expect to have a tax rate of 15% because you retired, it would be beneficial to recharacterize the $10,000 Roth IRA and reconvert the IRA at the lower 15% tax rate later this year,” Hopkins said. “In this case, it would save you $2,000, or 20% of your account.”
Hopkins also agreed market volatility plays a big role in recharacterizations.
“As the recharacterization deadline approaches you should carefully watch the value of the assets you converted,” he said. “If the assets have dropped in value since the conversion, you should consider a recharacterization. You will not get the value of the old investments back but you will get the taxes back.”
Hopkins again used the example of someone who converted $10,000 of stock in an IRA in 2014 and paid $2,500 of taxes on the conversion. Today, however, that same stock is only worth $5,000 — and if you recharacterize the Roth IRA you will get back the taxes and can convert later this year at the new lower amount. When the person re-converts the stock again at $5,000, they will now only pay $1,250 of taxes assuming the same tax rate, he added.
“The Roth IRA recharacterization is one of the rare second chances provided in the tax code,” Slott said. “You get a do-over, which is not the case with most other tax decisions. The benefit of a Roth recharacterization is that you can remove the tax liability resulting from a Roth IRA conversion where the market value declined.”
Hopkins added a recharacterization is like a "take-back" if you change your mind in the future, allowing you to undo a Roth conversion.
“Remember that you can do a partial recharacterization,” he said. “However, be sure you know the exact amount and assets that you will recharacterize. In some cases, it is helpful to set up a new Roth IRA when doing a conversion to keep assets separately and make recharacterizations easier.”
Hopkins also said to wait until the last minute when considering a recharacterization, don't overreact due to small day to day changes in the market.
“Your conversions, IRAs, and Roth IRAs are part of a long-term strategy, so don't get overly worked up if the value of your assets drop 5%,” he said.
Slott concluded at a minimum, everyone who converted to a Roth IRA in 2014 should evaluate that conversion to see if they might benefit from a recharacterization.
“People should also know that a recharacterization is not at all final,” Slott said. “If you still want to have those funds in a Roth IRA, after the recharacterization, those funds can be re-converted” after waiting 30 days.
“Then you’ll only pay tax on the value at re-conversion, which will result in a lower tax bill if the value of the original conversion declined,” he said.