`Recharacterize' your Roth and cut tax bill

Undoing IRA conversion would reduce impact of market downturn

Dollars & Sense

March 04, 2001|By Jeff Brown | Jeff Brown,KNIGHT RIDDER/TRIBUNE

How different things were a year ago. All the major stock indexes were soaring, adding to the wonderful gains of 1999. Then, stocks plummeted.

As if this weren't bad enough, early in the year many investors converted their traditional IRAs into Roth IRAs, only to see the value of their holdings shrink. Unfortunately, the conversion triggered a tax bill that comes due this spring. Had these folks waited to convert when prices were lower, the tax bite would have been substantially smaller.

Are you in this boat?

Then, cheer up! In the strange world of IRAs, you can get a second chance through a procedure known as a "Roth recharacterization." It allows you to, in effect, undo last year's conversion - wiping out the tax bill you would otherwise face in April. Then, if you would still rather have a Roth, you can do the traditional-to-Roth conversion all over again when prices are low, minimizing the tax bill.

"I think a lot of people are going to look at this when they get close to filing their tax returns," predicts Tom Pudner, personal financial planning manager for accounting firm KPMG LLP.

A Roth conversion done last year can be recharacterized to a traditional IRA anytime through Oct. 15.

To many investors, Roths are more attractive because, unlike traditional IRAs, they have no tax on withdrawals in retirement. Also, the Roth investor is not required to begin minimum withdrawals after turning 70 1/2 . (There is no annual income or capital gains tax on profits earned in either type of account.)

Federal tax rules allow people who have traditional IRAs to turn them into Roths. But there's a catch: You have to pay income tax on any converted assets that would have been taxed on withdrawal from the traditional IRA.

The tax is owed on investment gains as well as any original contributions that were tax-deductible when they were made. This income tax is owed for the year in which the Roth conversion is done, based on asset values the day of the conversion. That stings, but it can pay off, because subsequent investment gains are tax-free.

Roth conversions are especially attractive to people who expect to be in higher tax brackets in retirement. By converting, an investor might be able to pay tax at a 28 percent rate today rather than a 36 percent rate later.

But consider this example put together by IRA expert Ed Slott, a Rockville Center, N.Y., accountant:

An investor who converted a $100,000 traditional IRA account into a Roth early last year would have owed income tax on the whole $100,000 (unless a portion of the account was from contributions that had not been tax-deductible; no tax would be due on those).

Now suppose that account is worth only $60,000 today, perhaps because it was full of technology stocks or funds. Were the conversion done today instead of last year, the tax would be owed on $60,000 rather than $100,000.

To take Slott's example another step: If this investor were in the 28 percent income tax bracket, she would have triggered a $28,000 tax with the early-2000 conversion, but she would face a tax of only $16,800 if the conversion were done now - a difference of $11,200.

This investor is a prime candidate for a recharacterization, which would wipe out the $28,000 tax bill. If she still thought the Roth preferable over the long term, she could again convert the account into a Roth. Ideally, she would do this while the account's value was still low, because the new Roth conversion would trigger an income tax just as the first one did.

An account can be converted into a Roth only once each calendar year. Also, assets converted from a Roth to a traditional IRA cannot be converted back into a Roth for 30 days.

In other words, if our investor had converted her traditional IRA into a Roth early in 2000, she could recharacterize now, turning it back into a traditional IRA and wiping out the tax bill she had triggered last year.

Then, after 30 days, she could turn it back into a Roth, triggering a new, but lower, tax bill that would be due in April 2002.

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