A Couple of Year-End Roth IRA Strategies

With stock market indices down 30% or more from their January 1st levels, most investors are battered, bruised, and hoping for happier times. In the midst of a generally depressed stock market, there are still a couple of clever ways to make the most of a bad situation using a Roth IRA.

Roth Conversion
If your Traditional IRA account balance has been walloped by the vagaries of this year’s market and you intend to keep it invested in stocks or stock mutual funds, now is a good time to consider doing a conversion (or partial conversion) of the funds into a Roth IRA.

Since a Roth conversion is a taxable event, you’ll have to pay additional income taxes if you convert – but since your account value is lower now than it was several months ago, the extra tax you owe as a consequence of the conversion will also be lower. A conversion made before year-end will result in additional 2008 income tax liability.  Even though the account is down now, if you’re planning to keep the funds for 10 or 15 more years, you have the opportunity to pay a smaller tax than you would have paid to convert earlier this year.

There are several caveats here – if you have any IRA accounts that contain pretax dollars, make sure you understand the effect this has on a Roth conversion. Put simply, in this situation part of the conversion will be taxable and part will not, and the details can be complicated. There are also special tax rules that apply if an annuity contract is held in the account that is being converted. To do a Roth conversion this year, your modified adjusted gross income (MAGI) must be less than $100,000.  Finally, be aware that you need to be able to pay the additional tax that will be due from a source other than the IRA account if you are under age 59 1/2.  Otherwise, if you take money out to pay the tax, you’ll also owe a 10% tax penalty for the conversion.

Roth Recharacterization
Paradoxically, this year’s down market may also provide a reason for someone who has done a Roth conversion earlier this year to consider undoing it. This kind of “Roth un-conversion” is called a recharacterization.

Why might you want to do a recharacterization this year? Well, suppose that you are in the 28% tax bracket and you converted $50,000 into a Roth earlier this year; that means you owe additional $14,000 in income taxes. Let’s say that the account is now worth $35,000. If you leave the account as it is, barring a huge (and improbable) upturn in the value of the account before year-end, you’ll now effectively be paying 40% of your account balance in taxes for the conversion, which you may not wish to do. If you recharacterize the Roth funds properly back into a traditional IRA, the conversion tax liability disappears. You have to do a bit of paperwork, but it could be worth the trouble.

The astute reader should now be thinking, “Hey, if I recharacterize my Roth conversion and then convert it right back again at the lower account value, I’ll still be able to convert, and my taxes will be lower.” It’s a great idea, but the folks at the IRS are way ahead of you. Several years ago, the IRS banned “same-year reconversions:” if you recharacterize a Roth conversion you may not move those funds out again into the new Roth until either

the tax year following the year of the original conversion, or

31 days after the recharacterization,

whichever is later.

In other words, if you converted to a Roth earlier this year and recharacterize today, you can’t do another Roth conversion until 2009; you lose the opportunity to do a 2008 conversion.  If you break this rule and try to do a premature conversion, it is treated as a “failed” conversion, which means the IRS treats it as a taxable distribution from the original IRA subject to taxes plus a 10% penalty (if this applies).

The deadline for doing a recharacterization is the tax return due date, including extensions, for the year of the contribution that is being recharacterized.  Obviously, this can get a little complex, so it’s good to be sure you know what you’re doing to avoid messing things up and experiencing unintended tax consequences.

Finally – if you do recharacterize, you must recharacterize all funds originally converted, plus any earnings that have accrued since conversion.

Using one of these strategies may or may not be a wise move for you; as always, you should consult a tax or financial advisor if you don’t have sufficient knowledge of the tax laws to determine accurately the financial impact of a rollover or a recharacterization.  There are several ways to goof up one of these strategies if you don’t understand the rules.

About the author

Thomas Fisher, CFP®
Thomas Fisher, CFP®

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