Recharacterizing a Roth IRA

Traditional IRA vs Roth IRAIf you converted a traditional IRA into a Roth account sometime during the 2013 tax period, you can switch back again — provided you make the change prior to October 15, 2014. Known as “recharacterization,” this move may lead to tax savings in certain types of situations and should therefore be taken into consideration as part of your overall tax strategy.

In general, individuals ought to take advantage of recharacterization rules in the following circumstances:

Decline in asset value

Since taxes are calculated on the value of assets at the time of conversion, it often makes sense to recharacterize if those assets suffer a drastic decline within the next calendar year. For example, if an individual converts a $50,000 traditional IRA to a Roth account and an economic downturn subsequently devalues the assets to $25,000, the individual’s tax liability would still be for the full $50,000 starting value. Rolling back to a traditional IRA would remove the tax burden incurred from the initial conversion.

Reversing individual contributions

In addition to entire accounts, individual contributions to traditional or Roth IRAs may be recharacterized as well. This move is advisable when eligibility issues arise—such as when an individual exceeds the tax-free threshold on traditional IRA contributions for a given tax year—or if the individual simply feels that one or the other type of account makes better financial sense at the moment.

Lower tax bracket

A third case in which recharacterization of a Roth IRA might be warranted is if you currently find yourself in a lower tax bracket than in the previous year. For example, converting a $10,000 traditional IRA to a Roth account while in the 25% tax bracket would place your liability at $2,500. If your income dips to the 15% tax rate in the next year, recharacterizing your Roth account back to a traditional IRA would reduce your tax liability to $1,500 and net $1,000 in tax savings.

The decision about whether or not to recharacterize your Roth IRA can be a complex one with far-reaching ramifications, including possible penalties for miscalculations and/or missed deadlines. To help figure out if a Roth recharacterization is in your best financial interests, consult with one of our tax specialists before this year’s October 15 cutoff.