Roth IRA conversions have been in the headlines a lot in 2010, since the income cap for conversions went away. Fidelity recently did a study, however, and found that only 30% of investors who are eligible for Roth conversions were aware of the ability to undo those conversions via re-characterization.
In the game of golf, a mulligan is a do-over - a chance to retake a tee shot that you took and wish to pretend didn't happen so you can do it again. As we've discussed here before, many folks have an opportunity to convert traditional IRAs (usually with tax-deferred savings) into Roth IRAs (with savings which will not be taxed in the future). Since the beginning of 2010, the opportunity to make such conversions has been expanded - at first only folks whose AGI was less than $100,000 were permitted to make IRA->Roth IRA conversions, but now anyone can, though the potential tax consequences of doing so may be complex (see our article "Can I put money into a Roth IRA?")
Potentially more surprising is the fact that it's not necessarily a done deal. If you convert from a traditional to a Roth IRA, you likely will owe taxes on most, if not all, of the amount converted. However, if for some reason you decide that you're rather not have done that conversion, and there are several reasons which make it worth seriously thinking about, you have until your tax filing date for the year of the original conversion (or contribution) to undo it. And that includes the extended deadlines for tax filing (for details, see our article on extended deadlines for undoing conversions.)
The ability to undo things applies not just to conversions from a traditional to a Roth IRA, but also to direct contributions to an IRA. If you'd contributed to a Roth IRA but meant to make the contribution to a traditional IRA, or vice-versa, re-characterization may be used to correct that as well.
Why can we re-characterize? Well, we don't necessarily want to speculate too deeply about why Congress does what it does, but the reason here is probably due to the fact that until 2010, not everyone was actually allowed to convert traditional to Roth IRAs, and whether or not one was allowed to do so depended on one's income -- which one may not have actually been able to calculate until the end of the year or even later and therefore, if one had made a conversion during the year and then found out later, perhaps as late as tax-filing, that one made too much money, there had to be an out, a way to fix the problem. While the income cap for conversions has gone away, there's still an income cap for direct contributions, so if one had contributed to a Roth IRA during the year and then found out, say, in December, that he was getting a big bonus which pushed his income above the limit, again, there had to be a way to undo it. Hence, the ability to re-characterize contributions and conversions and the deadline being not the end of the year, but rather, the tax-filing deadline (by which time, one certainly should know if one was permitted to make the conversion or contribution.)
So now we've discussed one possible reason why one would want to re-characterize - income and the ability to actually have made the contribution or conversion in the first place. There are a couple of other excellent reasons worth considering and the implications can sometimes be a bit complex so if you are considering some of these, we highly recommend discussing them with your investment and tax advisors.
Unwanted conversion - suppose after making the traditional->Roth IRA conversion you found out that the implications of having that additional taxable income were unfortunate? While having that extra taxable income (and paying taxes on it) may have been something you'd considered and planned for, it may turn out that later on you realize that it wasn't such a good idea after all. The additional taxable income may have adverse implications for financial aid for which you were applying. Or it turns out that you don't have the cash on hand to pay the taxes associated with that extra income (and you almost certainly don't want to take the cash out of the Roth to pay the taxes, since you may be hit with a penalty for that as well).
Market losses - suppose you had $10,000 in the traditional IRA and you converted it to a Roth. Now you've got $10,000 in the Roth (and you owe income taxes on as much as $10,000). And then the market goes down so that your account is now worth only $8,000. You can't do anything about the market - that's done. But don't you wish you'd waited and done the conversion now so you'd only owe income taxes on the $8,000? Or not done it at all? Guess what - you can. Re-characterize the conversion back to the traditional IRA, and now you don't owe any taxes due to that conversion at all. And now, if you want, you may still re-do the conversion and you'll only owe taxes on as much as $8,000 instead of $10,000. There are a couple of restrictions on reconversions like this. In particular, the reconversion cannot apply to the same tax year, so if you'd converted to a Roth in 2009, then before filing your 2009 taxes, you re-characterize back to a traditional IRA, you cannot reconvert again for the 2009 tax year - your reconversion will have to wait for 2010 (and likely be taxable on your 2010 taxes). You also cannot reconvert for at least 30 days after the re-characterization. Fairmark has some great examples showing how this works here.
If you have been considering a Roth conversion, a traditional IRA contribution and/or Roth IRA contribution, or you've already done any of these things for 2009, you may have until, at the very latest, October 2010 to undo them. And if you're considering or have done any of these things for the 2010 tax year, you have a good while ahead to keep this possibility in mind. Remember, Mulligans aren't just for golfers.