When it comes to retirment planning, it’s easy to make mistakes. If you converted a traditional IRA into a Roth IRA last year before the stock market free fall, for instance, you may be especially forlorn — most likely your Roth IRA is now worth considerably less than it was on the conversion date. Even worst: You’re stuck paying 2008 taxes on phantom value that no longer exists.
Thankfully, you can reverse that ill-advised Roth conversion. In fact, you can make it so it’s like the conversion never happened, and as a result, that inflated conversion tax bill will also disappear.
Even better, you have until October 15 to accomplish the reversal. (The deadline applies whether or not you extended filing your 2008 Form 1040 to that date.) However, if you plan to hold stocks in your IRA, and you think the market is headed up from here, you may want to get the reversal done ASAP.
Here’s how Roth conversions work:
The tax hit. When you converted your traditional IRA into a Roth account, the trasaction was treated as a taxable distribution from the traditional IRA, followed by a contribution of the distributed amount to the Roth account. So the conversion triggered a federal income tax bill (and possibly a state income tax bill) based on the traditional IRA’s value on the conversion date, minus any nondeductible contributions made to that account.
(This assumes that the traditional IRA that you converted was the only one that you owned. If you hold multiple IRAs, the taxable percentage of the converted traditional IRA balance is based on the total balance of all your traditional IRAs and the total of all nondeductible contributions to those accounts.)
Now, thanks to the rocky stock market, that Roth IRA is most likely worth a lot less than it was on the conversion date, which means you’ve paid 2008 taxes on money you no longer have — unless you reverse the conversion by the October 15 deadline.
Reporting the reversal. Using Internal Revenue Service lingo, you reverse an ill-advised conversion by “recharacterizing” the Roth account back to traditional IRA status. By doing so, it’s like the conversion never happened: The tax hit disappears, and you’re right back where you started with no tax harm done. To reverse a conversion, you need to fill out the proper form supplied by the brokerage firm or financial institution that serves as your IRA custodian or trustee.
The custodian or trustee should have reported to you, and to the IRS, the deemed distribution that resulted from last year’s Roth conversion on a 2008 Form 1099-R.
Amending your 1040. If you have yet to file your 2008 Form 1040 because you extended filing your return, simply enter the Form 1099-R distribution amount on line 15a. Then enter a taxable amount of zero on line 15b. These two entries will show you had a conversion and a subsequent reversal — with the net result of zero taxable income.
If you’ve already filed your 2008 Form 1040, you’ll need to file an amended return, using Form 1040X, to show the reversal and collect your rightful tax refund. On line 1 of Form 1040X, subtract the amount of taxable income that was triggered by the now-reversed conversion, and calculate the reduced 2008 tax bill on lines 6-10. Then explain on page 2 of Form 1040X that the changes are due to reversing the 2008 conversion.
Of course, by reversing the conversion in 2009, it will trigger a 2009 Form 1099-R from your IRA custodian or trustee, reporting the deemed distribution from reversing the Roth account back to traditional IRA status. So on this year’s Form 1040 (which you’ll file next year), you’ll enter the Form 1099-R distribution amount on line 15a. Then enter a taxable amount of zero on line 15b. These two entries will show that you had a conversion reversal that did not result in any 2009 taxable income.
Reconverting after a reversal. Converting a traditional IRA into a Roth account can still be a great idea if you get the timing right. Therefore, you might want to reconvert the reversed account from traditional IRA status back into Roth status all over again.
Reconverting makes sense if the account is loaded with assets you believe will appreciate quickly. That way, when all is said and done, you’ve still converted the same traditional IRA into a Roth, but you’ve done so at a lower tax cost than when you tried the first time last year.
There is a timing restriction, however. For an account that was originally converted to Roth status in 2008 and then reversed back to traditional IRA status in 2009, you have to wait at least 30 days after the reversal date to reconvert.
Here’s an example: Say you orginally converted your traditonal IRA into a Roth in 2008 when the stock market was healthy. Then the account took a big nosedive, so you reverse it back to traditional IRA status on August 1, 2009, to avoid an inflated 2008 tax bill. The earliest you can reconvert the account back into a Roth IRA is August 31, 2009 (30 days after the reversal date.)