Deadline for Reversing 2012 Roth Conversions Is Closing

TaxConnections Picture - VaultIf you converted a traditional IRA into a Roth account last year and are now unhappy with the results, you can reverse the conversion as long as you get it done by October 15th. Here’s what you need to know as this deadline rapidly approaches!

Reversal Basics

When you converted your traditional IRA into a Roth IRA last year, the transaction was treated as a distribution from the traditional IRA followed by a contribution of the distributed amount to the Roth account. So the conversion triggered a 2012 federal income tax bill (and maybe a state income tax bill, too) based on the traditional IRA’s value on the conversion date.

However, 1 taxpayer-friendly aspect of the Roth conversion drill is that individuals who use the calendar year for tax purposes have until October 15th of the year following the conversion year to reverse a conversion. For example, you have until October 15th of this year to reverse a 2012 conversion. That October 15, 2013 deadline applies whether or not you extended your 2012 Form 1040.

When to Reverse a Roth IRA Conversion

You accomplish a Roth conversion reversal by “recharacterizing” the Roth account back to traditional IRA status. This is done by turning in the proper form to your Roth IRA trustee or custodian.

To illustrate, say you converted two traditional IRAs, Account A and Account B, into two Roth accounts in 2012. Account A has gone up in value since the conversion date. But Account B has plummeted in value and is now worth significantly less than on the conversion date.

In this suboptimal situation, you would have to pay income tax on the value of Account B on the conversion date, even though its value subsequently took a nosedive. Thankfully, you have until October 15, 2013 to recharacterize Account B back to traditional IRA status. After the recharacterization, it’s as if the ill-fated conversion never happened, so you won’t owe any 2012 income tax on the conversion of Account B. In other words, the 2012 conversion of Account B is reversed this year with no tax harm done.

Key Point: What you do with Account B has no effect on Account A. You can leave Account A, the converted account that is performing well, in tax-free Roth IRA status.

What if the Roth IRA Includes Other Contributions?

Matters are more complicated if your Roth IRA includes other contributions besides the 2012 conversion contribution that you now want to reverse. In this case, it may not be possible to simply recharacterize the entire Roth account back to traditional IRA status.

For instance, if the Roth IRA includes contributions for pre-2012 tax years, it is now too late to recharacterize the part of the account balance that is attributable to those pre-2012 contributions. However, up to the October 15, 2013 deadline, you can still reverse the account balance that is attributable to the ill-fated 2012 conversion by filing the appropriate forms with your IRA trustee or custodian.

You will have to instruct your IRA trustee or custodian how much you want moved back into a traditional IRA. Most trustees or custodians can help calculate the amount converted in the current year less any related losses.

Tax Return Implications

If you extended the filing deadline for your 2012 Form 1040 to October 15, 2013, and have not yet filed the return, you reflect the reversal of the 2012 Roth conversion by simply not including the income triggered by the conversion on your return.

If you have already filed your 2012 Form 1040, you’ll have to file an amended 2012 return to delete the conversion income and claim a refund for the related tax bill. Consult your tax adviser for full details about filing an amended return.

Limited Time Offer

In many cases, converting traditional IRAs into Roth accounts is a savvy tax planning strategy. But that’s not true when the converted account quickly plummets in value. When the value of your investment tanks after the conversion date, you wind up paying taxes on account value that no longer exists.

The conversion recharacterization (reversal) privilege is specifically intended to prevent that problem, but the deadline for reversing 2012 conversions is almost here. Contact your tax adviser as soon as possible if you are interested in reversing an ill-fated 2012 Roth IRA conversion.

In accordance with Circular 230 Disclosure

Ronald J. Cappuccio, J.D., LL.M. (Tax), business and tax attorney, has more than 30 years of tax and business law experience. As a lawyer since 1976, admitted to practice before NJ State and Federal Courts, including the US Tax Court and the Court of Federal Claims, I have helped clients from around the U.S. as well as multi-national clients. I have dedicated my life to agitating people – especially the IRS and government functionaries. I have never worked for the IRS and therefore I do not have to worry about them as former colleagues. Fighting the government so you can keep your money is just plain fun for me!

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