The market free fall of 2008 was relentless. Many clients who did a Roth conversion last year have seen their account values decline, some drastically so. These clients now have a tax bill on value that they no longer have.

For example, in early 2008, assume Allen converted $100,000 to a Roth IRA at a 25% effective marginal bracket, generating a $25,000 tax bill for the conversion. If Allen's account is worth only $30,000 today, he now must pay income tax on $70,000 of account value that no longer exists.

Fortunately, though, in one of the great breaks provided by the tax code, clients like Allen can recharacterize their Roth accounts and eliminate the tax liability on the lost account value. Simply stated, a Roth recharacterization is the process of undoing a Roth conversion by transferring the converted funds back to an IRA. Anyone can do a recharacterization for any reason. After the recharacterization, the funds are treated as if they never left the IRA.

Now is the time to look at recharacterization opportunities for any client who converted plan or traditional IRA funds to a Roth in 2008 because the deadline to recharacterize those conversions is Oct. 15, 2009. The recharacterization must be done as a trustee-to-trustee transfer.

NOTIFY THE CUSTODIANS

So what comes next? Once you have identified those clients who should recharacterize their Roth conversions, how do you actually go ahead and do it?

Roth recharacterization rules apply to all funds that are converted to a Roth IRA, including SEP, SIMPLE IRAs and employer plan funds. The custodians of both the Roth IRA (where the money currently is) and the traditional IRA (where the recharacterized funds will go) must be notified in writing of the recharacterization. Although the custodian for both the Roth IRA and the traditional IRA may be the same, they are often different institutions.

The recharacterized funds do not have to go back to the original account. In fact, if 401(k) funds were converted to a Roth IRA, they are recharacterized to a traditional IRA, not back to the 401(k).

In all cases, the custodial notification must include the following six pieces of information:

* The type ("conversion" in this case) and dollar amount of the contribution (conversion) to the Roth IRA that is to be recharacterized. The number of shares and the specific assets that were converted are irrelevant for this purpose, as is the present value of those assets. What matters is only the value at the time the conversion took place. For a full recharacterization of a $100,000 conversion, the amount to be recharacterized is $100,000, even if the value is now only $20,000.

* The date on which the retirement funds were converted to the Roth IRA.

* A direction to the Roth IRA custodian to do a trustee-to-trustee transfer to the traditional IRA custodian (again, the assets can remain with the same custodian). As mentioned previously, the recharacterization must be done as a trustee-to-trustee transfer. It cannot be done as a rollover. Clients can request that shares or specific assets be transferred back to the traditional IRA. However, after doing the math for the net income calculation, it may not be the same number of shares that were converted in the first place.

* A direction to the Roth IRA custodian to transfer the amount of the conversion and any net income (or loss) allocable to the conversion. This is where the adjustment is made for the loss of value on the converted amount. The custodian should determine the gains or losses on the entire account balance and determine how much of that gain or loss is attributable to the conversion amount that is being recharacterized, but not all custodians will do this calculation.

Remember, it does not matter how many shares or what assets were converted. At this point, the only thing that matters is the value of those shares at the time of the initial conversion.

* The names of the Roth IRA and the traditional IRA custodian (they may be the same). The recharacterization does not have to go back to the same IRA that it came from. It simply must go back to any traditional IRA.

* Any additional information needed to make the transfer. Your clients have until the tax filing date of the year of the conversion, plus extensions, to recharacterize. In effect, that is Oct. 15 of the year after the conversion, regardless of whether the return is filed by April 15 or an extension is requested. If a return has already been filed, though, it may need to be amended.