Should I Convert My IRA then Change My Mind?

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Question: I want to convert my traditional IRA, which has a value of approximately $100,000, to a Roth IRA.  My tax professional says that if I convert now I will have to pay income tax on the $100,000 when I file my tax return next spring.  But I am worried that the market may drop later this year.  Should I wait until it drops to convert? Or should I convert now? Since I am in the 40% combined Federal and State tax bracket, conversion will cost me $40,000 in taxes on top of my normal taxes.  If the market drops by 20% before I convert then I will pay $32,000 in tax, saving $8,000.   What should I do?

Answer:  Investment decisions would be a piece of cake if only we could predict the stock market.  But we can’t, and there isn’t any evidence that anyone can consistently time stock price movements

When an IRA owner converts, it is because he or she expects the value of the account to increase, which it will do over time if the owner invests it wisely.  Since you can’t time the market, I suggest you go ahead and convert if that is what you want to do.  The market may not drop and may even go up.

If your account goes down in value the IRS gives you an out by allowing you a period of time to change your mind and undo the conversion.  The IRS calls the process of changing your mind “recharacterization.”  You can recharacterize any time after the day you convert until October 15th of the following year, which is the last day to file an income tax return for the conversion year if you were to elect to extend your tax return filing date beyond April 15th.  Even if you file your tax return prior to April 15th, you can still recharacterize as long as you meet the October 15th deadline.  In other words, you do not have to be on extension to be eligible.

The procedure is simple.  You contact your IRA custodian, tell him what you want to do, fill out his forms, turn them in, and you’re done.  Don’t wait until the last minute.  Give your financial institution some time to do the job. 

If you have already filed your income tax returns before you recharacterize, you can simply file amended returns that show the calculation of your income tax without the Roth conversion and report the characterization on Form 8606, which you attach to the amended returns.  The IRS and the California Franchise Tax Board each have their own Form 8606.  You have three years to file the amended returns, although you may want to file the amended returns right away to get your refund.

After you recharacterize you will once again have a traditional IRA account.  If you recharacterized because of a drop in the value of your account and you want to convert back to a Roth IRA, you must wait until the beginning of the tax year after the conversion or 30 days after the recharacterization, whichever is later.  If you do reconvert, you will end up paying tax on the now lower value of your traditional IRA.

Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment manager and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning.  Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA  93940 or email them to ken@montereypw.com.