Ask the Expert: Doing and undoing Roth IRA

I know someone who converted a $100,000 traditional IRA into a Roth IRA. Now, the Roth is worth $125,000. He wants to eliminate the tax on the conversion by reconverting the $100,000 back to a traditional IRA. But he wants to leave the $25,000 gain in the Roth. Doesn't he have to roll back the whole $125,000? 

Yes. If he wants to undo the Roth, he must roll back the whole $125,000.

Most people decide to undo a Roth that has lost value. Here's why: When you convert a traditional tax-deferred IRA into a Roth IRA, the following April you owe income taxes on the amount you converted. (You hope the Roth IRA's tax-free earnings eventually will more than make up for this initial cost.) Your tax on the conversion doesn't change even if the Roth IRA has lost value: If you converted $100,000 in January 2011, for example, and by April 15, 2012, it's worth only $75,000, you still owe taxes on $100,000.

You can eliminate the tax on $100,000 by undoing -- or, as tax professionals say, "recharacterizing" -- your conversion. "To undo the conversion, you move whatever is left in the Roth account back to the traditional IRA," says Ed Slott, a Rockville Centre tax accountant. The deadline for undoing a 2010 conversion is Oct. 17, 2011. For a 2011 conversion, it's Oct. 15, 2012.

Your friend has a gain instead of a loss, but the same rule applies. He can't undo the conversion and also keep the $25,000 gain from that conversion, says Slott.

He advises your friend to keep the Roth. It makes no sense to move $125,000 from a tax-free Roth into an IRA whose distributions will be taxable, just to avoid paying a tax that's already covered by his gain.

The bottom line. After you undo a Roth IRA conversion, the Roth IRA no longer exists.

More information. Click here and here to read more on recharacterization at  bit.ly/qtChND or bit.ly/njlrZZ

To ask the expert, send questions to Ask the Expert. Act 2, Newsday Newsroom, 235 Pinelawn Rd., Melville, NY 11747-4250, or email act2@newsday.com. Include your address and phone number. Questions can be answered only in this column. Advice is offered as general guidance. Check with your own advisers for your specific needs.