Under new rules that took effect in 2010, you can convert a traditional IRA into a Roth IRA no matter what your income is. If the conversion turns out to have adverse tax consequences, you'll have plenty of time to reverse the whole transaction.
The article below is accurate for your 2017 taxes, the one that you file this year by the April 2018 deadline, including a few retroactive changes due to the passing of tax reform. Some tax information below will change next year for your 2018 taxes, but won’t impact you this year. Learn more about tax reform here.
Starting in 2010, even high-income individuals can convert traditional IRAs into Roth IRAs. Previously, you were ineligible if your modified adjusted gross income (MAGI) exceeded $100,000.
With the playing field now wide open, Roth conversions will likely be more popular than ever. Inevitably, you may wish to reverse some of those transactions, perhaps due to poor investment performance. You have until October 15th of the year after making a conversion to reverse it and avoid the related tax liability. Before we cover the details of reversing a conversion, let’s go over some background information.
Conversions are taxable transactions
Let’s say you convert a traditional IRA into a Roth in 2010. The transaction is treated as a distribution from the traditional IRA, followed by a contribution of the distributed amount to the new Roth account. If you only have one traditional IRA, the amount of the distribution to be taxed equals the account balance on the conversion date minus any nondeductible contributions.
- For example, say you have a traditional IRA worth $50,000 to which you made $5,000 in nondeductible contributions. The taxable distribution amount is $45,000. If you didn’t make any nondeductible contributions, the taxable distribution would be the entire account balance of $50,000.
If you own several traditional IRAs, you must aggregate (add together) all their balances and nondeductible contributions to determine the taxable distribution. Because the aggregation rule makes the taxable distribution the same no matter which account you convert, you can’t reduce the taxable distribution amount by converting an IRA with a larger proportion of nondeductible contributions.
You can reverse a conversion
If the investments in your new Roth IRA lose value after the conversion, you’ll have an adverse tax outcome, because the taxable distribution from the conversion will still be based on the value of the account on the conversion date. In other words, you’ll wind up owing taxes on money you no longer have.
- Going back to our example, let’s say the value of the Roth IRA drops from the initial $50,000 to $35,000. You’ll still have a $45,000 taxable distribution from the conversion, even though the Roth account is now worth only $35,000.
Fortunately, you can avoid this unfavorable outcome by reversing the Roth account back to traditional IRA status. The IRS calls this process recharacterizing the account. Once the recharacterization is complete, you’re right back where you started, tax-wise—though your IRA is now worth $35,000 instead of $50,000. To summarize: the conversion is reversed, the $45,000 taxable distribution disappears,(along with the related tax liability), and the account is again a traditional IRA worth $35,000.
Mind the deadline
To reverse a conversion by recharacterizing an account back to traditional IRA status you must submit the required form to your Roth IRA trustee or custodian by October 15 of the year after the conversion takes place. If October 15 falls on a weekend, the deadline is the following Monday. This flexibility makes the conversion idea that much more appealing.
If you’ve already filed your tax return for the year of the conversion but it isn’t yet October 15, you still have until that date to reverse the conversion (with extra days in years when October 15 falls on a weekend). To get back the tax you paid on the conversion you would then need to file an amended tax return (using Form 1040X) by the due date for amended returns. (Usually you have three years after the date you filed the original return, but you shouldn’t wait that long to seek a refund from reversing a Roth conversion.)
What to show on your tax return
When you make a Roth conversion, your IRA trustee or custodian reports the resulting distribution to you on Form 1099-R, which you should receive by February 1 of the year after the conversion. If you choose to reverse the conversion TurboTax can lead you through the necessary tax reporting.
You can reconvert later
While poor performance by Roth investments may prompt you to reverse a conversion, you might want to reconvert that same account into a Roth IRA later on. Reconverting the account when it has a lower balance will mean a lower taxable distribution and a reduced tax hit. However, Congress has placed timing restrictions on reconversions. For an account that was originally converted to a Roth in 2016 and then reversed to a traditional IRA in 2017, you have to wait until 30 days after the reversal date to reconvert. If you reverse a 2017 conversion in 2017 you can’t reconvert the account before January 1, 2018.
The tax law rarely gives you this much flexibility so the Roth conversion idea deserves some serious consideration. For instance, if you decide to convert in early 2016, you would have nearly two years to evaluate the results of the conversion to make sure it was the right move for you. If not, you can reverse the deal under the rules explained earlier.
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