IRS Rules for a Roth IRA Reconversion

There are various reasons for doing a reconversion: you converted too much and cannot manage the tax burden, or you didn't meet the current conversion eligibility requirement but will next year or maybe your post conversion declined in market value and you want to capitalize on the decline for lower tax liability. A reconversion in any of those situations could be used to the benefit of the account owner; however, certain provisions must be followed.

You may undo all or part of your contribution or conversion through a re characterization. The IRS allows for re characterizations up until your tax-filing deadline, including any extensions, which puts you no later than October 15 to correct any ineligible contribution or conversion. If an ineligible contribution or conversion is not corrected by the October 15 deadline, you will be subject to failed conversion rules. Reconversion cannot take place until the year following a completed re characterization. Furthermore, reconversion can't be done within a 30-day window of a re characterization. Disregarding these provisions will result also result in a failed reconversion and be subject to failed conversion rules.

Failed conversions are treated as an traditional IRA distribution and Roth IRA contribution. Therefore, the distribution will be taxed as ordinary income and be subject to an early withdrawal penalty for individuals under age 59 ½ , not qualified for an early withdrawal exception during the year of the failed conversion. If the failed conversion amount exceeds your Roth IRA contribution limits, a 6 percent excise penalty will be assessed on the excess every year it remains in the Roth. So be sure to follow the provisions carefully to avoid a failed conversion altogether.

Reconversion is a great way to optimize on market downswings. The IRS bases your tax liability on your IRA balance on the day of the conversion. If your conversion had a higher market value on the day of conversion versus the end of the year, re characterize your conversion in December to take advantage of the market decline. Reconvert those assets 31 days later and reduce taxes owed to Uncle Sam.

Conversions should be based on financial strategy, not timing the market. It is recommended to re-characterize in December due to market unpredictability, unless you weren't eligible for the conversion or your finances changed and you cannot cover the conversion tax liability. Re-characterizing too early in the year will run you the risk of higher tax liability if there's a market upswing by the end of the year. Therefore, keep your re characterization and reconversion close together to minimize risks due to market volatility.