IRA Alert

Roth IRA strategies for a rocky market

For clients with IRAs that have stumbled of late, time is right to consider Roth IRAs

Sep 24, 2007 @ 12:13 pm

By Ed Slott

While recent stock market declines may worry some investors, those with stocks and funds in their individual retirement accounts can take advantage of current market volatility by making key moves.

If your clients’ IRAs have taken a hit and lost some value, then take advantage of the decline by suggesting they convert all or any part of traditional IRA funds to a Roth IRA, if they qualify. To qualify for a Roth IRA conversion, adjusted gross income cannot exceed $100,000, and the investor cannot file a separate return, if married.

The investor will owe tax on any traditional IRA funds converted to a Roth IRA, but since the value of the shares are down, the conversion can be accomplished at a lower tax cost, or more shares may be converted. The funds or shares must be transferred directly to a Roth IRA.

How can this pay off? Once the shares are in a Roth IRA, they grow tax free forever (once the Roth IRA funds are held for five years, and the investor has reached age 59½). Even if an IRA has lost half its value, if all of it is converted, the investor will pay only half the tax he would have paid had he converted it at full value.

Tax-free appreciation

It’s really like a half-off sale. Once the funds are in the Roth IRA, any future appreciation will be tax exempt. If the market comes back, as it usually does over time, all of that growth will now be reclaimed tax free. When stocks in an IRA decline in value, think of it as a Roth IRA sale and take advantage of it.

The opposite strategy can also pay off. Let’s say an investor converted some or all of his traditional IRA funds to a Roth IRA in 2006 and already paid the income tax on those conversions, when stock values were higher. The investor can get a do-over. In fact, one of the rare second chances available in the tax code is the ability to undo a Roth conversion.

The process of undoing a Roth conversion in tax talk is called a “Roth recharacterization,” and the tax law says it can be done until Oct. 15 of the year following the year of the conversion. If an investor converted traditional IRA funds to a Roth IRA in 2006, they would have until Oct. 15, 2007, to recharacterize that conversion and get a tax refund of tax paid on value that no longer exists, even if they had already filed a 2006 tax return. That’s like getting to bet on a horse after the race is over.

Here’s an example:

Say an investor converted $100,000 of traditional IRA funds to a Roth IRA in 2006. They paid federal tax on the $100,000 of conversion income, which might have cost $30,000, plus any state income tax. Since then, the market took a hit, and the value of that Roth IRA has dropped to $60,000. The investor would have until Oct. 15 to recharacterize any or all of last year’s Roth conversion.

To do that, the investor must make a direct transfer of the funds from the Roth IRA back to a traditional IRA. The funds are now treated as if the Roth conversion never happened and any tax paid on the conversion is refunded. If your client already has filed their 2006 return and paid the tax, they must file an amended tax return to receive a refund of tax paid on value that no longer exists. This must be done for state tax returns, as well.

Now the $60,000 is back in the traditional IRA. The value is still down, but at least your client no longer owes tax on $100,000.

This would be a great time to reconvert the $60,000 to a Roth IRA, but there is a waiting period on reconversions — until either the beginning of the year after the conversion or until 30 days from the recharacterization to reconvert, whichever is later. So in this example, if your client recharacterized the $100,000 Oct. 15, they must wait until Nov. 15 (30 days) to reconvert those funds to a Roth IRA. Once they reconverted, they would pay tax on only $60,000, since that would be the current value. When the market went back up, and the $100,000 value were restored in the Roth, the $40,000 increase would escape tax forever.

Ed Slott, a certified public accountant in Rockville Centre, N.Y., has 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 irahelp.com.

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