Since the traditional individual retirement arrangement was established in 1974, and Roth IRA accounts came much later, some people have been saving in their traditional accounts for a long time. You now have an option to convert your traditional IRA account to a Roth IRA, and take advantage of the tax benefits these accounts offer. If you later decide that the conversion was not for you, you have a time period to undo your conversion, or recharacterize your IRA account.
If you have funds in a traditional IRA, you can choose to convert these funds to a Roth IRA account without restriction. Before 2010, you could only convert your traditional IRA to a Roth if your income was below a certain amount. To convert your account, you must tell your IRA trustee that you wish to perform the conversion. Your trustee should complete the paperwork necessary, and you will need to report the amount converted on your income tax forms and pay income taxes on the converted funds at your current income tax rate.
Distributions from a Roth IRA at retirement are tax-free, including the investment gains. Traditional IRA distributions are taxable at your normal income tax rate. The tax-free income from a Roth IRA is a significant benefit, particularly if you expect to be in a higher tax bracket at retirement. A conversion may make more sense if you are younger, and the money in your IRA has more time to grow tax-free. However, older people may at times wish to convert their traditional IRA to a Roth to help with estate planning.
Recharacterization is basically a conversion of a conversion, or when you undo a previously done conversion. To recharacterize, you inform your IRA trustee of your decision, and they will complete the necessary paperwork. You have a limited timeframe to complete the recharacterization, as it must be completed by October 15 the year after you made the initial conversion. When recharacterizing, your conversion is treated like it never happened.
If your investments do not perform well, and lose value after you convert your traditional IRA to a Roth, you have paid taxes on the value of the money that you converted that doesn't exist anymore. By recharacterizing your conversion back to a traditional IRA, you can file an amended income tax return and recover the taxes that you paid when you converted the funds. You can then convert the IRA again and pay the taxes on the lower amount, but you must wait either one year after the original conversion, or 30 days after the recharactorization, whichever is longer.