Recharacterizing a Roth IRA conversion may save money on future taxes

Not only did their retirement savings shrink when the Standard & Poor's 500 index fell 16 percent in three weeks. Suddenly, they faced the prospect of paying thousands of dollars more in taxes than otherwise necessary. That's because the tax cost of changing an account is fixed at the time it's formally converted by your brokerage or investment firm.

Roth IRAs provide tax-free growth and have surged in popularity because of both their long-term tax and savings advantages and the relaxing of rules in 2010 that barred those with incomes above $100,000 from converting.

But the market drop left many of those who joined the rush to convert to them regretting their decisions because they still must pay taxes on the higher amounts that sat in their accounts last year. Investors flooded financial advisers with calls and emails about getting out of their Roths in early August, before stocks turned higher.

They still have more than a month to undo them. Unlike with a bad stock purchase, a do-over is possible with Roth conversions until deep into the following tax year.

This year, those who want to ditch the Roths they established in 2010 because of adverse tax consequences or any other reason have until Oct. 17 to undo or “recharacterize” them. Those who do so will avoid paying the tax bill for the conversion or, if they already paid, get their money refunded.

“It's a way to save a lot of money during a down market for those who have seen their account values depreciate significantly,” says Ryan Himmel, a New York CPA who heads BIDaWIZ Inc., an online marketplace for tax and financial advice. “You're leaving money on the table if you're not considering this.”

Reversing a Roth also can push large tax obligations into the future, when you may have more cash to absorb them.

That was the case for the Segals of suburban Cleveland. They converted a chunk of their retirement savings to a Roth in March on the advice of their financial planner. Then they reversed course weeks later when they realized just how hefty the tax bill would be and that it would push them into a higher tax bracket.

Barb, a retired medical educator, and Allen, a physician, both 60, said they needed the cash instead for current expenses such as paying down the mortgage.