Making Shrewd Roth IRA Decisions

The Roth IRA is one of the best investment tax shelters Congress ever created. But volatile markets add some complications to Roth IRA decisionmaking. If you converted a traditional IRA into a Roth IRA earlier this year or if you are considering a conversion, you should keep an eye on the markets before and after your decision.

You get no upfront deduction for creating a Roth IRA or for contributing money to it. But qualified distributions from the Roth are tax-free. All you have to do is leave the money in the Roth until at least age 59 1/2 or five years after the contribution, whichever comes later. Also, there are no required minimum distributions for the original owner of a Roth IRA. Money can be left to compound in the Roth IRA until it is needed, or it is passed to the next generation. Those factors make it a potentially more powerful wealth building tool than a traditional IRA.

You can convert a regular IRA into a Roth any year in which your adjusted gross income is no more than $100,000, not counting any converted amount. (The $100,000 limit applies whether you are a married couple filing jointly or a single taxpayer.) You can convert all or a portion of an IRA. The price of the conversion is that you must pay income taxes on the converted amount. You owe the same income taxes you would owe if you took a distribution instead of converting the IRA, but there is not 10% penalty for those under age 59 1/2.

It is best to pay the taxes from other assets and convert the entire regular IRA into a Roth. That way the maximum amount of assets stays invested and compounds tax free within the Roth IRA – and eventually is distributed tax free. My studies show that converting a traditional IRA into a Roth increases wealth if you let the IRA compound for at least 10 years after conversion and pay the taxes with non-IRA assets. It takes longer for the conversion to make sense if you use IRA assets to pay the taxes.

The payoff might take less time if your tax bracket in retirement will be higher than your tax bracket today. Pay taxes today at the lower rate and withdraw money from the Roth IRA tax free when, without the conversion, the money would have been taxed at a higher rate.

But there’s a potential pitfall to conversion. You pay taxes on the market value of the IRA at the time of conversion. That means it is worth your while to pay attention to market fluctuations and try to make the conversion during one of the market’s periodic declines.

But what if, despite your best efforts, the market declines after the conversion and drags down your new Roth IRA’s value with it? I know this happened to a number of people who converted early in 2001. Now, their Roth IRAs are worth substantially less than they were at conversion. They paid taxes on wealth they no longer have.

Fortunately, the tax law leaves you an out. You are allowed to “recharacterize” a Roth IRA conversion. In effect, you re-convert the Roth IRA back into a regular IRA. You don’t owe taxes on the conversion and are back to owning a regular IRA.

Suppose back in January you converted a $100,000 regular IRA into a Roth IRA. It was invested in index funds, so its value declined to $80,000. You aren’t happy that you paid taxes on $100,000 of assets. The tax law says that you can opt to recharacterize so that you don’t owe taxes on wealth that has disappeared.

Another reason to recharacterize is when your tax bracket will be substantially lower next year or the year after than it is this year. That might be the case with the tax cut being phased in.

You also might want to recharacterize the Roth IRA if your employment situation changed. You might no longer have a job and need to save the cash instead of paying taxes. In any of those cases, it makes sense to reverse the conversion. Do the conversion in a year when you will be in a lower tax bracket.

You might be required to recharacterize a Roth IRA. That occurs when you converted believing your adjusted gross income would be no more than $100,000. But things changed and now your AGI will exceed $100,000 and you are not eligible to convert this year. Everything in the Roth IRA must be transferred back to a regular IRA. Even if the Roth IRA now is worth more than at the conversion, the additional income and gains must be transferred back in a trustee-to-trustee transfer.

Once you have done a conversion to a Roth IRA, then a recharacterization back to a regular IRA, you cannot convert to a Roth IRA again until the later of the following tax year or 30 days after the recharacterization.

A recharacterization is simple. You are allowed to reverse the conversion any time up until the final due date for your tax return, including extensions. You can delay the decision until Oct. 15 of the year following the conversion. The recharacterization is done on Form 8606 filed with your regular tax return, or with Form 1040X (amended tax return) if you already filed the regular return.