Deadline Looms for Roth Do-Overs
You're eligible for a do-over -- something the IRS doesn't give very often -- but only if you act by Oct. 17.
In a Roth IRA conversion, an investor "converts" a traditional IRA to a Roth IRA, paying the taxes owed today in exchange for future tax-free benefits. They've become very popular with investors who like the idea of tax-free income for retirement.
"Just a few months ago, the conversions were a slam dunk, but some people now may have Roth accounts that are below [where] they were valued at the time of conversion," says Howard Hook, a New Jersey-based certified financial planner and certified public accountant. "While long-term the account values may come back, in the short term, (investors) may pay tax on a larger amount than they have to."
Instead, you can take advantage of the do-over, which could save you thousands of dollars on your tax bill.
When you invest in a traditional IRA, the account enjoys tax-free growth, but when you withdraw the money, you owe taxes on your withdrawals.
The introduction of the Roth IRA changed the retirement savings landscape. Withdrawals from Roths are tax-free, and that's made these accounts popular. Another plus to a Roth? Unlike traditional IRAs, there are no Required Minimum Distributions (RMDs) when you reach age 70 1/2.
Since 1998, taxpayers with an adjusted gross income of less than $100,000 have been permitted to "convert" their traditional IRAs to Roths. That income threshold was removed in 2010, so now anyone can convert an account.
A conversion is essentially a penalty-free early withdrawal -- even though the amount you take out is going straight into the Roth. That means you'll have to pay taxes now on the amount you convert, but when you eventually make withdrawals from the Roth, no further taxes will be owed.
For conversions done in 2010 only, there is a special bonus: Taxpayers are allowed to defer some of the tax bill, spreading what's owed over two years -- 2011 and 2012. For future years, the taxes have to be paid with that year's tax return.
If you converted your traditional IRA to a Roth in 2010, here's where the do-over -- called a "recharacterization" by the IRS -- comes in.
Hook offers this hypothetical example:
Jane, who is in the 30 percent tax bracket, converted $100,000 of her traditional IRA to a Roth IRA in 2010. The tax bill for the conversion was $30,000 (30 percent of $100,000).
On Sept. 20, 2011, her Roth IRA account was worth $80,000 because of stock market losses.
She would still have a tax bill based on the original $100,000 she converted.
But she has a choice. She can undo the conversion -- in IRS-speak, "recharacterizing" the conversion -- which means the money would go back to the traditional IRA and she wouldn't owe any taxes. After waiting 30 days, she can reconvert the $80,000 to a Roth, giving herself a lower conversion tax bill of $24,000.
The IRS gives taxpayers until Oct. 15 of the year following the Roth conversion to make this move. Hook notes that this year, the deadline is Oct. 17 because the 15th falls on a Saturday.
Whether or not you should seize the do-over opportunity depends on when you made the conversion.
"Stock market returns in 2010 and through June 30, 2011, were quite positive," Hook says. "Many people who performed Roth IRA conversions saw their accounts rise quite a bit through June 30. However, since June 30, the market is down quite a bit, and depending on when the conversion was done, many Roth IRA accounts may be down below the amount originally converted."
How To Do It
Recharacterizing your IRA is a matter of paperwork, but you must meet the deadline.
Call the investment company that holds your IRA -- your custodian -- and request a form to recharacterize the account, says Andrew Samalin, a New York-based certified financial planner.
"For safety's sake, don't leave it until the last minute, to avoid any processing issues with the IRA custodian," he says.
Make sure to fill out the form correctly, placing the correct accounts in the "transfer to" and "transfer from" columns.
"Accidentally transferring from the wrong account could result in an additional amount converted rather than recharacterized," Hook says.
Sounds simple, but you're not done yet.
After a week, call the investment company and make sure it has processed the form correctly. Ask for a written confirmation, or check your account online. If you wait to receive your October statement in the mail, it will be too late to fix any errors made by the investment company, Hook says.
If you converted in 2010 and recharacterize, and you plan to reconvert the account to a Roth, remember that you will lose the opportunity to spread your tax liability over two years, Hook says.
More on Conversions
Conversion is not an "all or nothing" process.
An investor can choose to convert one IRA, several IRAs, or a portion of an IRA.
If your traditional IRA has lost value, you may want to consider a Roth conversion now.
"The amount of the tax due in the year following the year of the conversion is based on the value of the account at the time of the conversion," Samalin says. "Therefore, the logic for converting the account during a period of market weakness is that the amount upon which the conversion tax is due will be lower, due to either market forces or individual security circumstances."
Even if your traditional IRA account has lost value, conversions aren't right for every taxpayer, Hook says.
Hook says a conversion may make sense if:
- You expect to be in a higher tax bracket when you retire, so you prefer paying taxes on your IRA today to enjoy future tax-free withdrawals.
- You have unusually large tax deductions in a given year. The deductions can offset some of the taxes owed on the conversion.
- You don't want to be forced to take Required Minimum Distributions because you don't expect to need the extra cash at that time.
- You're concerned about estate planning. Taxpayers can pass their Roth IRA accounts down to children who may be in a high tax bracket, Hook says.
Converting is probably not a good idea if:
- You expect to be in a lower tax bracket when you're retired.
- You will need the money from your Roth sooner than five years.
- You can't afford the tax bill on the conversion. "Using money from your IRA account to pay the tax usually does not make sense, either, so unless the taxpayer has money outside their retirement plans that they can allocate to pay the tax, it probably is best not to convert," Hook says.
Whether you convert your existing IRAs, consider making your next retirement contribution to a Roth, so you can add tax-free income to your retirement plan.
"The Roth IRA is a powerful tool, either as a stand-alone strategy or one to augment your retirement plan," Samalin says. "In times as tenuous as some consider them to be today, we should take any benefit the government offers."