IRA Alert

October Roth IRA opportunities

How to turn conversion lemons into lemonade for your clients 

Sep 22, 2008 @ 12:01 am

By Ed Slott

For financial advisers who want to help clients take advantage of a down market, mark Oct. 15 on your calendar. 

That is the last date for re-characterizing, or undoing, a Roth IRA conversion from the previous year. An example illustrates why this might be an effective strategy right now. 

Sue had $100,000 in a traditional individual retirement account in October 2007. She converted that IRA to a Roth IRA that month on the day when the Standard & Poor's 500 stock index reached its highest level in history, closing at 1,565.

Early this year, Sue filed her tax return and sent $28,000 to the Internal Revenue Service for her Roth IRA conversion — paying a 28% tax. But now, this month, she no longer has $100,000 in her Roth IRA. 

In this example, she has just $30,000 left because her IRA was invested in financial stocks, which fell sharply. Thus, Sue paid $28,000 in federal income tax for an account worth just $30,000. 

Fortunately, her adviser has followed up on her account and suggested that she re-characterize her Roth IRA. The deadline for re-characterization is Oct. 15.

By that date, Sue must re-characterize her Roth IRA to a traditional IRA as a trustee-to-trustee transfer in order to undo her 2007 Roth IRA conversion. (An adviser with the proper authorization can handle the re-characterization for her, making sure that it gets done by the deadline. Get proof in writing to confirm the transaction.) 

If the re-characterization is completed on time, Sue can file an amended tax return for 2007. She will get back the $28,000 in tax she paid on the now-annulled Roth IRA conversion, and she will also receive interest for the time that the IRS held her money. 

Sue's example may be extreme, but the concept is valid for anyone who converted a traditional IRA to a Roth IRA in 2007. Last year was a good year for stocks, the final year of a five-year bull market, so anyone who converted in 2007 probably has seen a decline in Roth IRA values during this year's and this month's pullback. 

The greater the decline in Roth IRA values since a 2007 conversion, the more a re-characterization by Oct. 15 makes sense. This is one of the great second chances in the tax code; it is like betting on a horse race after it is over. 

Our example assumes that Sue already has filed an income tax return for 2007 and has paid the tax on her Roth IRA conversion.

However, many taxpayers requested automatic filing extensions so that their returns won't be due until Oct. 15. Those taxpayers who wish to re-characterize also must do so by Oct. 15.

When the re-characterization is done before the 2007 tax return is filed, taxpayers will report both the conversion and the re-characterization on their 2007 tax return and pay no tax on these transactions. 

Whenever a client does a Roth IRA re-characterization, make sure that a trustee-to-trustee transfer is implemented. No check should be issued to the client, because such a payment can't be re-deposited in a traditional IRA.

Once a Roth IRA has been re-characterized, you have another chance to demonstrate your expertise as a proactive financial adviser by recommending a Roth IRA reconversion, perhaps as soon as 31 days later.

Continuing with the above example, suppose that Sue re-characterizes her Roth IRA conversion Oct. 13. On that date, she has $30,000 in her traditional IRA.

IRS rules say that a taxpayer must wait until the latter of 30 days or until the year after the previous conversion to re-convert. Sue's previous Roth IRA conversion was for 2007 so she can re-convert this year. 

Because she re-characterized that conversion Oct. 13, she must wait 30 days to reconvert her traditional IRA to a Roth IRA. The 30-day period ends Nov. 12, so Sue can do her reconversion Nov. 13.

Even if the stocks in her traditional IRA go up to, say, $35,000 in that 30-day period, she will still pay a lot less tax than she paid on her $100,000 conversion in 2007. 

As tax rates are at historically low levels, a Roth IRA conversion will be relatively inexpensive. You might want to advise all clients whose income won't exceed $100,000 to convert traditional IRAs to Roth IRAs now.

They stand to benefit by taking advantage of today's depressed stock prices and low tax rates. It is like a double sale on Roth IRAs.

Low tax rates plus low market values equal lower taxes now.

Ed Slott, a certified public accountant in Rockville Centre, N.Y., created The IRA Leadership Program and Ed Slott's Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at

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