When you file your tax forms, you report contributions to an IRA or Roth IRA. You also report completed conversions (and corresponding tax liability) from one type of account to another. Finally, you can use your tax forms to reverse your conversion by recharacterizing your Roth IRA back to a Traditional IRA.
In 2010, income limits for Roth IRA conversions went away, and thousands of people converted traditional IRAs to Roth IRAs, paying income taxes on investment gains. The rationale for this was that the account holder could pay taxes on gains to-date, but would never have to pay taxes on any additional gains.
For most people, conversion was a great way to avoid long-term tax liability. But in some cases, the conversion may no longer be the best move. You might decide to permanently reverse your conversion, or reverse your conversion and re-convert at a later date (at least 30 days after completing the reversal).
Why to Reverse your Conversion
There are many reasons to reverse your conversion. Some include:
- Your account lost money since conversion, so you paid taxes on gains that no longer exist – you can reverse, then re-convert and owe less money.
- You are or expect to be in a lower tax bracket than last year – as above, you can reverse and reconvert, owing less money.
- You paid taxes on gains using money that you need for an unexpected expense – you can reverse and get back any tax that you paid in
How to Reverse your Conversion
To “reverse” your conversion, you actually need to recharacterize your Roth IRA to an IRA. You must do so on your tax return for the year in which you initially converted, meaning your ability to reverse your conversion is time-limited. To complete the recharacterization, follow these steps:
- Decide if you are ready to reverse your conversion now, or if you need more time to decide
- If you need more time to decide, file a tax extension, which will permit you to file your returns as late as October 17 (although you still owe tax payments by the April 18 deadline). Alternatively, you can file in April and submit an amended return by October 17.
- Notify the financial institution that maintains your Roth IRA of your desire to recharacterize. They should be able to walk you through gathering the required information, which should include the date and amount of the initial conversion.
- Report your reversal on your tax returns (Form 8606) for the year in which the conversion took place.
Note that you can also recharacterize IRA contributions made last year as Roth IRA contributions, or vice-versa. We previously wrote about reasons for doing this and the recharacterization process, which is identical to the one outlined above.
For an in-depth discussion of conversion and recharacterization strategies, see “Roth IRA Conversions – An Agressive Strategy”