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Everyone has times in life when they wish they could have a “do over,” including investment decisions. It’s much like the buyer’s remorse that sometimes looms after making a large purchase, such as a new car or electronics. But what if you could go back and change a mistake—and even undo the payment of taxes?

One way you can do just that is when you recharacterize your Individual Retirement Account (IRA) contributions.

What Is a Recharacterization?

A recharacterization is when an investor changes how a certain contribution or investment is treated. This typically refers to how taxes apply to the investment. Most often, recharacterizations happen when you change your contribution type from a Traditional IRA to a Roth—or a Roth back to a Traditional. When investing in an IRA, you must choose whether or not the investment is for a Traditional IRA (your investment is tax deferred; no taxes until you make withdrawals in retirement) or a Roth IRA (you make your contributions with after-tax dollars, but retirement withdrawals are tax free).

The prime rationale for converting Traditional IRAs to Roth IRAs is that people feel that taxes may go up in later years and it would be cheaper to pay them now. They like the Roth’s tax-free withdrawals at retirement, and the fact that Roth IRAs have no required minimum distributions during the owner’s lifetime. 

But, sometimes circumstances that change after the conversion make you rethink whether this was such a good idea.  if you change your mind after converting, you will need to recharacterize your investments back to their original classification.

Reasons to Recharacterize Your Roth

You may wonder why you would need or want to change how your IRA is designated. Does it really matter? Sometimes it does and making the change could save you quite a bit of money.

Your contribution may benefit from a recharacterization if the value of your investments has declined since the time you made the conversation from Traditional IRA to a Roth. Another important reason is that your contribution was deemed ineligible and you want to avoid penalties. Or, you might have simply changed your mind.

Recharacterizing Your Roth IRA After a Loss

One of the main reasons people choose to recharacterize a Roth IRA into a Traditional IRA is because their investments have suffered serious losses since their conversion. For example, if you have a Traditional IRA with a balance of $100,000 that you converted into a Roth IRA, you will owe taxes on that conversion. If you are in the 28% tax bracket, your tax bill would be $28,000 to the federal government.

Imagine that after the conversion, your IRA melted down like most investments did in the Great Recession year of 2008, losing 30% of your portfolio’s value. You would still owe $28,000 in taxes, despite your account balance dropping to $70,000. If you recharacterize your investment back into a Traditional IRA, you would not owe the tax bill.

Summary

There can be strong financial benefits from converting a Traditional IRA into a Roth IRA. The amount of future tax savings can be quite substantial. But when the market drops sharply, investors may have buyer’s remorse about their conversion.

It is nice to know that there is an option to recharacterize your Roth IRA contributions if need be. Just be sure you follow the rules and do it before the deadline (six months after your tax return is due).

 

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