When you convert a traditional IRA to a Roth IRA, you include the value of your traditional IRA, reduced by any nondeductible contributions you’ve made, in income for federal tax purposes in the year of the conversion. But what happens if the value of your Roth IRA subsequently declines, making the conversion a bad deal from a tax perspective? No problem. The IRS lets you recharacterize (undo) a conversion, if you act in a timely fashion.
For example, assume you convert a fully taxable traditional IRA worth $50,000 to a Roth IRA in 2012. You include $50,000 in income on your 2012 federal income tax return. But shortly after the conversion, the value of your Roth IRA declines to $25,000. Now you’re suddenly faced with the proposition of paying taxes on $50,000, while your Roth IRA is worth only $25,000.
All is not lost–because of the recharacterization rules, you have until your tax return due date (including extensions) to undo all or part of a conversion if it no longer makes good financial sense. So in this example, you have until October 15, 2013, to recharacterize. (Similarly, if your conversion occurred in 2011, you have until October 15, 2012, to undo the conversion.)
When you recharacterize, you need to withdraw the amount you originally converted, plus any earnings, out of the Roth IRA and transfer it back to a traditional IRA. To simplify the calculation of earnings if you decide to recharacterize, you should consider using a new Roth IRA for each conversion. You might also consider using a different Roth IRA for each separate investment, or class of investments, you plan to make–this way, if one investment goes down but another goes up, you can recharacterize only the Roth IRA that declined in value (you don’t need to aggregate your Roth IRAs for this purpose). If you wish, you can always combine Roth IRAs later after the recharacterization deadline passes.
If you convert a traditional IRA to a Roth IRA in 2012 and then recharacterize, you’ll have to wait until January 1, 2013, to reconvert those same dollars (and any earnings) to a Roth (or, if later, the 31st day following the recharacterization). However, any other traditional IRA dollars you have can be converted to a Roth IRA without restriction.