Get a Bear Market Do-Over

As a kid playing, when things went wrong, you could always ask for a do-over. The decline in the stock market over the past year has a lot of investors wishing they could do the same thing.

Of course, stocks won't give you a do-over -- you're stuck with your losses. But if you took advantage of a tax-saving strategy early this year and had it backfire on you, you might be able to get a partial do-over and take advantage of subsequent losses to save on your tax bill right now.

Why Roth is right
Foolish readers know well the many benefits of Roth IRAs. They're the ultimate tax-favored account; as long as you follow some simple rules, you'll never have to pay income taxes again on either the money you put in or the income that your investments earn.

Because Roth IRA holders get so many benefits, tax-savvy investors often consider taking their existing traditional IRAs and converting them into Roth IRAs. You'll pay taxes now, but in exchange for accepting the tax liability early, you get a free pass on income taxes until you or your heirs take it out of the account.

Undoing bad timing
The problem, though, is that if you jumped the gun on converting your Roth this year, you've probably seen some significant losses in your account. That's unfortunate, because you get the biggest benefit from a tax-free account when you have gains and other income.

Amazingly, the IRS gives taxpayers an opportunity to call a do-over on investment losses. Known as a recharacterization, the tax laws basically let you undo your conversion, wiping out the tax liability you would've had to pay.

How you can save
Here's an example. Say you had a traditional IRA holding 100 shares of seven different companies. You decided to convert your account to a Roth on the first trading day of 2008. The taxable income you'd have to put on your 2008 tax return next April would be based on the account value as of that date. But look how much your account value would have dropped since then, using some large-cap companies as examples:

Source: Yahoo! Finance.

If you do nothing, you'll have to pay tax on the value as of Jan. 2, which was $60,763. If you're in the 25% marginal rate, that means additional tax of more than $15,000. Yet with a Roth recharacterization, you can undo your conversion and pay nothing.

Have your cake and eat it, too
In fact, now's a great time to consider a recharacterization, because as the end of the year approaches, so too does the opportunity to lock in the gains from the strategy.

Specifically, after you recharacterize, doing a Roth conversion again later can save a bundle. By converting when stocks are down, though, you'd save a huge amount. For instance, in our example, if your portfolio value stays the same as it was on Nov. 28, then you'd only have to include $30,647 of taxable income -- more than $30,000 less than you would have without the recharacterization, saving you roughly $7,500 in taxes.

The problem is that you can't recharacterize and then do another conversion in the same year. But by recharacterizing at the end of 2008 and waiting 30 days, you can try for a conversion again in early 2009 and reap the benefits.

Using tax-favored accounts requires knowing a lot of tricks. But by doing your homework, you can save thousands by making smart moves like Roth recharacterizations. If you've converted an IRA to a Roth this year, be sure to talk to your accountant about whether getting a bear-market do-over through a Roth recharacterization could pay off for you.

For more on making the most of a down market:

• How not listening to Buffett cost one investor thousands.
• Make more money by being less greedy.
• Six signs of winning stocks.