Death & Taxes

Save Money on IRA Changes

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By Roy Lewis
July 26, 2002

Did you know that you're allowed to transfer your traditional IRA stash to a Roth IRA? Sure you did. It's called a conversion from your traditional IRA to a Roth IRA. It's a slick deal. You pay taxes now on the value of your conversion, and then get to live with the tax-free Roth IRA rules down the line.

Did you also know that you could make conversions with stock? Sure can. You don't even have to sell your existing holdings (and thereby incur trading expenses). You can simply convert your existing traditional IRA stock holdings to your Roth IRA. The amount of the conversion is the fair market value of the shares of stock that you convert.

But with the good news (a Roth IRA) also comes the bad. Taxes. As we mentioned above, when you make a conversion, you'll get hit for taxes on the conversion income. That's the price you have to pay to get your traditional IRA moved over to a Roth IRA.

Sometimes when you convert stock to a Roth IRA, additional injury is added to the tax insult.

Dive! Dive! Dive!
What happens when you make your Roth IRA conversion with stock and the bottom falls out of the stock price? Are you stuck paying high conversion taxes on the original stock value when that same stock is now worth less (perhaps substantially less) than the value of those shares on the conversion date? Not necessarily. Let's see how this might happen.

Freddy Fool decided that a Roth IRA was for him. In February 2002, he converted shares out of his IRA account into a Roth IRA account. At the time of the conversion, the shares were valued at $30,000. Since Freddy is in the 28% tax bracket, he can expect to pay about $8,400 in federal taxes on this Roth conversion.

But, only a few months later, Freddy looks at this Roth IRA portfolio, and the value of those same shares has dropped to $10,000. Yikes! Sadly, it makes no difference that Freddy's portfolio value today is about one-third of the original conversion value. Freddy will still have to pony up the $8,400 in taxes when he files his 2002 tax return. The key is the value of the shares at the date of the conversion.

So, Freddy's pretty depressed, but he doesn't have to be. Freddy has the option to completely unwind his original conversion, move the shares back to his traditional IRA, and pretend the conversion never happened. How does he do that?

Freddy will make a recharacterization back to his traditional IRA from his Roth IRA. He'll simply transfer the stock back to his traditional IRA, and Uncle Sammy will allow Freddy to pretend the conversion never happened.

Freddy can ignore the $8,400 in taxes that he faced. It's really as if the original conversion transaction never took place at all. It's the mother of all "do-overs."

Reconversion issues
Is it really that simple? Well, as with all things tax, it isn't. There are some issues that Freddy needs to be aware of and understand.

First and foremost, once Freddy completes his recharacterization, he can't reconvert those traditional IRA funds to a Roth IRA until the later of:

  • The first day of the next tax year; or

  • Within 30 days of the date of the recharacterization

There was a time when Freddy could convert, recharacterize, reconvert, re-recharacterize, and re-reconvert ad infinitum, until he realized the tax liability he wanted. But no longer. Freddy really only has one bite at the apple under the current rules. Once Freddy decides to recharacterize his Roth IRA back to a traditional IRA, his options for making the transfer back to a Roth IRA are limited.

Recharacterization deadlines
Okay, let's say Freddy wants to recharacterize his Roth IRA back to a traditional IRA. Does he have to do so by the end of the 2002 tax year (since he converted his traditional IRA to a Roth that year)? No.

Freddy actually has until Oct. 15, 2003 to make this decision. What's the magic of the following-year, Oct. 15 date? That's the final date by which you have to file your income tax return (including all extensions) for, in this example, the year 2002.

This gives folks a number of months to watch the stock prices before making a decision to leave things as they are, or recharacterize.

Freddy's Follies
Now that we have some of the deadlines and time rules explained, let's use Freddy's example to see how they apply to various decisions he might make.

Freddy made his original conversion from his traditional IRA to his Roth IRA back in February 2002. If Freddy decided to make a recharacterization on Oct. 10, 2002, he would have to wait until Jan. 1, 2003 to make a reconversion (the first day of the next tax year).

If Freddy made his recharacterization on Dec. 20, 2002, he would have to wait until Jan. 19, 2003 to make a reconversion (the 31st day after the date of recharacterization... which is the later date compared to the beginning of the new tax year on Jan. 1, 2003).

If Freddy made his recharacterization on Jan. 18, 2003, he would have to wait until Feb. 17, 2003 to make a reconversion.

I think that you see the pattern here. But one important point: Any reconversions made in 2003 will be treated as 2003 conversions. Seems reasonable, right? So, a recharacterization will get you out of conversion taxes for 2002. But, a subsequent reconversion will then have an impact on your 2003 taxes.

So What?
Look what happens to Freddy if he elects to recharacterize his Roth IRA. Freddy decides to recharacterize his Roth IRA on Dec. 20, 2002, when the value of his shares is $10,000. Freddy can then ignore the $8,400 tax liability that he had anticipated for 2002. It simply goes away.

Freddy waits his required 30 days, and makes his reconversion to a Roth IRA on Jan. 19, 2003, when the value of his stock is still $10,000. Assuming that Freddy will be in the 28% bracket in 2003, his conversion tax will amount to only $2,800. That's a tax savings of $5,600... right now.

Since Freddy is a true Fool, he knows that he has invested in a good company and that the share price of the company will certainly increase in the future. Freddy also realizes that since the stock is now parked in his Roth IRA account, this increase in stock price will fall under the Roth IRA rules and will likely net him a tax-free distribution in the future.

The moral to the story is that if you made a stock conversion from your traditional IRA to a Roth IRA, and that stock has decreased in value since the date of the conversion, you might want to take a long hard look at the potential for saving yourself some tax dollars now and in the future by using a recharacterization.

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