Reversing a Roth Conversion: Good Idea or Bad?

Like many people, you may have taken advantage of the Roth individual retirement account (IRA) conversion option that was available in 2010. This was attractive at the time because it offered people a chance to take a traditional IRA and convert it to a Roth IRA by paying due taxes in a one-time event. After that the funds were treated and accounted for in an existing or new Roth account.

However, for those who suffered investment downturns due to the economy, some may have found that the additional conversion taxes owed made their situation worse. There is an out to this situation, but it requires reversing the Roth conversion that previously took place.

Conversion allowed taxes owed to be paid over two years if the conversion occurred in 2010. This means that the taxes would be due with the 2010 taxes as well as the 2011 taxes, which aren’t due yet until April 15 2012. If a tax filer did make a Roth conversion in 2010 and split it over two years, then a reversal may play out better in terms of avoiding a bigger than expected tax hit.

The advantages of implementing a conversion can be multiple. You may find your numbers are forcing you into a higher tax bracket and therefore a higher tax charge. A conversion can reduce your taxable income for the current year by placing the funds back into the pre-tax retirement account.

If it turns out that your retirement funds have suffering an investment loss after the conversion, the reversal gives you a second chance. You don’t get to recover the loss. However, by implementing the reversal you can put the equivalent funds back into the pre-tax account and, at least in terms of your retirement savings, start over again. You also get to avoid the related tax bill associated with the conversion.

With money freed up from a tax charge of conversion you can then use the funds to deal with other issue that may be important at the time such as medical expenses, an emergency, or a critical financial expense that wasn’t planned for earlier.

The disadvantages of a reversal include the major one which is your funds won’t sit in a Roth IRA account and will be subject to taxes in the future when you do finally withdraw them. Since many people are finding they are earning more in the senior years than they expected, there is a chance that taxes will be higher in the future at the time of withdrawal than right now. Further, all investment gain in the pre-tax account will be taxable again as well.

You will also be eventually required to make minimum withdrawals with the pre-tax account you have converted back to. The IRS requires that once people reach the age of 70 ½ years they must start pulling money out of the traditional IRA account still held. In the Roth IRA, your funds can stay as long as you want them to be deposited. In fact, if you wish it, the Roth IRA can be willed to a beneficiary intact, building tax-free and transferred by trust or estate planning in your final years.

Reversing a conversion should not be an automatic decision. You’re making a financial decision about your retirement savings that can have lasting effects on the funds. And what someone else did does not automatically mean their choice is the right path for your financial decision. The best approach is to study the alternatives, what they mean for your retirement and taxes, and then choose the best path that saves you the most now and in the future when you retire.


Turbo Tax: Reversing a Roth IRA Conversion

The Wall Street Journal; Reversing a Roth IRA Conversion; Bill Bischoff; June 2009

Sensible Investment Strategies; The Roth IRA – A New Way to Save; Jack Piazza

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