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When is a Good Time
for a
Roth
Conversion? |
When the value of your portfolio is down,
there can be an opportunity to save on taxes using a
Roth IRA. Take a look at two options:
No Income Limit
for Roth Conversions in 2010 and Beyond
Under current law, an
individual with modified adjusted gross income
(MAGI) above $100,000 cannot convert a traditional
IRA into a Roth IRA. A law passed in 2006
eliminates the MAGI limitation, but you’ll have to
wait for a long time to take advantage. The
favorable change will kick in starting with tax
years beginning after 2009. For Roth conversions
that occur in 2010 only, half of the taxable
income triggered by the conversion generally must
be reported in 2011 and the other half in 2012.
For conversions in 2011 and beyond, all the income
must be reported in the conversion year — as under
current law.
While it's
worth keeping this in mind when planning your
portfolio, Congress could decide to change its
mind later and eliminate this favorable provision
before it ever becomes effective.
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Don't worry about making a decision
that's set in stone. Uncle Sam gives you the
flexibility to convert to a Roth IRA, "unconvert"
to lower your tax bill if the stock market drops,
and then convert back again.
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Reprieve for a Roth IRA
Mishap Unlike traditional IRAs, Roth
IRAs are not subject to the “minimum distribution
requirements” for taxpayers over age 70
1/2.
IRS ruling:
An individual who was over age 70
1/2 converted an IRA to a Roth IRA in 1999.
However, his Social Security income was not
included on his return. The IRS picked up the
mistake in 2001 and increased his 1999 income,
which pushed him over the $100,000
threshold.
Fortunately, the IRS
showed the taxpayer some leniency. It granted him
six months to recharacterize his Roth to a
traditional IRA. The IRS also gave him until the
end of 2003 to take minimum distributions for 1999
and subsequent years. Normally, the penalty for
failing to take required distributions is 50
percent of the shortfall. (IRS PLR
200213030).
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 Consider converting your
regular IRA to a Roth IRA if the value has decreased.
Since you pay taxes based on what the account is
currently worth, the tax cost to convert is lower when
the value of your IRA is down.
On the other hand, if you
converted your traditional IRA to a Roth and the value
of the account has now dropped considerably, it may
pay to undo the conversion.
The rules are complex, so
let's start with the basics.
With a Roth IRA,
contributions aren't tax deductible but withdrawals are
tax-free after five years, as long as you're age 59 1/2
or older. In addition, you don't have to take required
distributions from a Roth IRA after age 70 1/2 so your
money can keep growing tax-free for decades.
In contrast, with a regular, deductible IRA, you get
an upfront deduction for contributions but you must
begin taking taxable mandatory withdrawals after you
turn 70 1/2.
So converting a regular IRA to a Roth IRA can pay off
in future tax-free income. However, the conversion
is considered a liquidation of your original IRA so you
owe tax on the amount withdrawn and placed in a Roth
account. The tax is due in the year the conversion takes
place. You must meet an income limit to be eligible.
For now, your adjusted gross income (AGI) can't
exceed $100,000 in the year of the conversion. The
$100,000 figure is the same for both single and married
joint filers. (See upper right-hand box for a future
change.)
The Market Effect
If your IRA is devalued, it might make sense to
convert to a Roth IRA because the tax bill will be
lower. Suppose, for example, you rolled over your
$500,000 retirement plan balance into an IRA. Now you
want to convert to a Roth account. Assuming a combined
federal and state tax bracket of 40 percent, converting
your $500,000 IRA to a Roth IRA will trigger a $200,000
tax obligation (40 percent times $500,000).
But if a bear market cuts the value of your IRA to
$400,000, you only owe $160,000 on a conversion (40
percent times $400,000). In this example, you save
$40,000 by converting after a market dip.
What if you converted to a Roth IRA last year when
your IRA was worth $500,000? Now your investments
in your Roth account are only worth $400,000 and
you already paid $200,000 in tax? You may be able
to change your mind and collect a refund by undoing the
conversion by the deadline. (The IRS calls this
"recharacterizing.")
To undo a 2007 Roth IRA
conversion, contact the trustee of your Roth IRA to have
the money rolled back into a traditional IRA by October
15, 2008. Then, file an amended tax return using IRS
Form 1040X.
If you undo a 2007 conversion, it
doesn't mean you're shut out of a Roth IRA forever. Once
you recharacterize to a regular IRA, you can switch back
or "reconvert" to a Roth IRA in the future and owe a
lower tax bill. But you have to wait 30 days after the
recharacterization.
Tip: When
converting to a Roth account, pay the tax bill with
non-IRA funds, if possible. The more money you keep in
your IRA, the greater the tax-free buildup you'll
eventually be able to enjoy.
And if you do
convert, keep in mind that the additional conversion
income will increase your AGI. That could disqualify you
for other tax-saving deductions, credits and exemptions
or make more of your Social Security benefits
taxable.
The Roth rules are tricky so consult
with your tax pro to determine the effect of any
decisions and ensure the best results for your
retirement funds.
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