Tax Tips
IRA Strategies for Market Declines
Shrunken IRA balances mean a smaller tax bill when you convert to a Roth IRA.
By Mary Beth Franklin, Senior Editor, Kiplinger's Personal Finance
December 11, 2008
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This year's bear market has a potential silver lining for IRA owners: If you decide to convert your traditional IRA to a Roth IRA, your market-battered balance will result in a smaller tax bill now and provide tax-free retirement income in the future. To be eligible for a Roth IRA conversion, your adjusted gross income can't exceed $100,000 regardless of whether you are single or married.
If you convert your IRA by December 31, you'll owe taxes on your 2008 return at your regular rate on the entire amount you convert. "A market decline gives eligible taxpayers a chance to convert a traditional IRA invested in beaten-down stocks or mutual funds to a Roth IRA at a much lower tax cost than would have been possible when stock market values were high," says Bob Trinz, senior tax analyst with the tax and accounting business of Thomson Reuters.
But keep an eye on your converted Roth IRA balance. If it continues to decline, you could get stuck paying taxes on the higher amount. However, you can undo the conversion by having the Roth IRA trustee transfer the converted amount and any related earnings back to a traditional IRA no later than the due date of your 2008 return (including any extensions through October 15, 2009).
This maneuver, which the IRS refers to as a "recharacterization," will treat your original Roth IRA conversion as if it never happened and there will be no tax consequences. As long as you wait at least 30 days, you can convert to a Roth IRA again.
IRA funds converted to a Roth must remain in the account for at least five years before they qualify for tax-free and penalty-free withdrawals of the converted amount (but not the earnings). Once you are 59 ½, all Roth IRA withdrawals, including earnings, are tax free.
Reader Comments (4)
Posted by: C Urban at 12/11/2008 01:51:18 PM
What does this statement mean? "But keep an eye on your converted Roth IRA balance. If it continues to decline, you could get stuck paying taxes on the higher amount." It is my understanding that the day your Trad IRA is converted, let's say $5000, that amount goes into earned income for the year and you pay taxes on that amount. What does it matter if the Roth IRA increases or decreases in value?
Posted by: Mary Beth Franklin at 12/11/2008 03:43:58 PM
Hi, I'm the author of this article. This is in response to C Urban: You are right that you owe taxes on the amount of money you convert from a traditional IRA to a Roth IRA this year. But you don't have to pay your taxes until you file your 2008 return by April 15, 2009 (Or Oct. 15, 2009 if you file an extension). So if the value of your Roth IRA has declined since you converted it, don't pay taxes on money you no longer have. Simply undo the Roth conversion. This step, officially known as a "recharacterization" simply transfers the money from your Roth IRA back to a traditional IRA. Wait at least 30 days--any time up to when you file your 2008 tax return-- and you can reconvert it to a Roth IRA and pay taxes on the lower converted amount.
Posted by: Bill Garrow at 12/12/2008 05:39:21 PM
Regarding recharacterization of IRAs converted to Roths back into IRAs: If some of the stocks or funds converted have gone up and others sunk because they were transferred at different times, can you recharacterize just those that have gone down or do you have to recharacterize all 2008 converstions?
Posted by: Zephyr at 12/12/2008 05:42:23 PM
Hi Mary Beth, I did a Rollover IRA to Roth IRA conversion before Dec 31'2008 and now I want to recharacterize. If I do that lets say in Jan. 2009 and convert back to Roth IRA in March'09, will the conversion amount be the earned income for year 2009, for tax filing purposes? Thanks