How different things were a year ago. All the major stock indexes were soaring, adding to the wonderful gains of 1999. Then, as you know, things went to pieces. Stocks plummeted.
As if this weren't bad enough, early in the year many investors converted their traditional IRAs into Roth IRAs, only to see the value of their holdings shrink afterward. Unfortunately, the conversion triggered a tax bill that comes due this spring. Had these folks only waited to convert when prices were lower, the tax bite would have been substantially smaller.
Are you in this boat?
Then cheer up! In the strange world of IRAs, you can get a second chance through a procedure known as a "Roth recharacterization." It allows you to undo, in effect, last year's conversion wiping out the tax bill you otherwise would face in April. Then, if you'd still rather have a Roth, you can do the traditional-to-Roth conversion all over again when prices are low, minimizing the tax bill.
"I think a lot of people are going to look at this when they get close to filing their tax returns," predicts Tom Pudner, personal financial planning manager for KPMG LLP, the accounting firm.
A Roth conversion done in 2000 can be recharacterized to a traditional IRA anytime through Oct. 15, 2001.
To many investors, Roths are more attractive because, unlike traditional IRAs, there is no tax on withdrawals in retirement. Also, the Roth investor is not required to begin minimum withdrawals after turning 70 1/2. (Of course, there's no annual income or capital gains tax on profits earned in either type of account.)
Federal tax rules allow people who have traditional IRAs to turn them into Roths. But there's a catch: You have to pay income tax on any converted assets that would have been taxed upon withdrawal from the traditional IRA. The tax is owed on investment gains as well as any original contributions that were tax deductible when they were made.
Roth conversions are especially attractive to people who expect to be in higher tax brackets during retirement. By converting, an investor might be able to pay tax at a 28 percent rate today rather than a 36 percent rate later.
Consider this example:
An investor who converted a $100,000 traditional IRA account into a Roth early in 2000 would have owed income tax on the whole $100,000.
Now suppose that account today is worth only $60,000, perhaps because it was full of technology stocks or funds. Were the conversion done today instead of last year, the tax would be owed on $60,000 rather than $100,000.
To take the example another step: If this investor were in the 28 percent income tax bracket, she'd have triggered a $28,000 tax with the early-2000 conversion, but would face a tax of only $16,800 if the conversion were done now a difference of $11,200.
This investor is a prime candidate for a recharacterization, which would wipe out the $28,000 tax bill. If she still considered the Roth preferable over the long term, she once again could convert the account into a Roth.
While this seems pretty straightforward, it can get quite complicated if you want to recharacterize just some of the stocks or funds in your IRAs. Moreover, if you have more than one IRA, each account can be handled differently you can recharacterize the ones that fell in value after they were converted to Roths, while leaving other Roths alone.
The brokerage or mutual fund company that holds your IRA can walk you through the process. Then, when you file your tax return for 2000, you must use Form 8606 to report what you did.
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