Just as 2010 may have been the year of the Roth conversion, 2011 may be the year of the Roth recharacterization. After clients visit their accountants and see the tax bill from their Roth conversions, many may get sticker shock and want to undo those conversions.

WORDS OF WARNING

Undoing may not be the best move, however. Before they recharacterize, make sure your clients are aware of the consequences.

* Caution 1: They will lose money. Don't let the tax bill scare your clients off. Even though they owe taxes on the 2010 Roth conversion, the income can be spread over two years (2011 and 2012), which can lessen the amount owed. In addition, tax payments can be deferred for two and three years.

Clients can actually pay less tax and have more time to pay it. That means holding on to their money longer while earning tax-free income in their Roth IRAs.

In addition, 2010 was a pretty good year for most investors, which means tax-free gains have already been locked in. Explain to clients that, if the Roth conversion is undone, these taxfree gains will be transferred back to a traditional (and taxable) IRA.

That only benefits Uncle Sam. Make sure the client sees the long-term big picture and does not let the tax bill overshadow the tax-free income already earned. The client only pays tax on the amount originally converted, even if the Roth IRA account balance is much higher now.

* Caution 2: They will blow the two-year deal. For Roth conversions completed in 2010 only, clients had the choice of spreading the tax due over 2011 and 2012 or paying it when they filed their 2010 taxes. If a 2010 Roth conversion is undone (recharacterized), then the two-year tax deal is lost for good. Even if the same funds are reconverted in 2011, the conversion is now a 2011 conversion and the two-year deal is not available. All of the 2011 Roth conversion income must be reported in 2011.

* Caution 3: They still have time. Even though the 2010 tax return was due on April 18 this year (the extra days were due to a holiday), your client could have filed his or her tax return by the April due date but still have until Oct. 17, 2011, to recharacterize a 2010 Roth conversion. So why rush? Why not take several extra months to see how the Roth investments fare? Maybe the added time will allow clients to reevaluate their decision.

Even if clients filed their returns by April 18, if they take the two-year deal (half the conversion income in 2011 and the other half in 2012), no 2010 Roth conversion income has to be included on the 2010 tax return anyway. If they still want to undo the 2010 conversion, they can always recharacterize up to Oct. 17, 2011, and report the recharacterization on an amended tax return.

* Caution 4: Their required minimum distributions will increase. Once a 2010 Roth conversion is recharacterized, the funds are treated as if they never left the traditional IRA. If the recharacterization is done in the year after the conversion, the Dec. 31 year-end IRA balance reported on the account statements will not be correct. If a client is subject to RMDs, that balance must be increased by the amount of the recharacterization.

For example, assume Joe is 75 and is taking RMDs from his IRA. He'll need to calculate his 2011 RMD, which is based on his Dec. 31, 2010, IRA balance of $500,000. In addition to taking his RMD in 2010, he converted $100,000 to a Roth IRA. In April 2011, he had his 2010 tax return prepared. For whatever reason, he decided to undo his entire 2010 Roth conversion.

Once he recharacterizes and the funds go back to his traditional IRA, his 2011 RMD calculation will change. He must add back the Dec. 31 value of his Roth conversion, which he recharacterized. So his 2011 RMD will be based on both a Dec. 31, 2010, IRA balance of $500,000 and the value of his Roth balance, even though his IRA statement will show a balance of $500,000.

* Caution 5: Clients may not be able to recharacterize the entire conversion. When some people converted in 2010, they did not have money outside of the IRA to pay the tax, so they held back some of the converted funds to pay the tax. That is generally a mistake to avoid at all costs. It is even more of an issue if the client was younger than 591/2 because that would also make any funds not converted subject to the 10% early withdrawal penalty.

But despite these drawbacks and ample warning, some clients held back some of their IRA funds to pay the tax on a Roth conversion anyway. If they now want to undo the conversion, they cannot recharacterize the amount withheld for taxes, so they will owe tax anyway and maybe a 10% penalty on the money not converted.