convert ira to roth ira?

raee_gwDecember 9, 2008

I am seriously considering taking advantage of the loss in value in my IRA to convert it to a Roth. If I sell some of my non-IRA shares at a loss, that will offset some of the tax hit, I am thinking, and I have some cash too to pay the bill.

Has anyone done this, or researched it? It seems that the advantage of a Roth--to have it grow tax free (hopefully!) and no taxes on withdrawals either would be to my advantage.

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I had seen an article on this subject in the WSJ, so I needed to do a search to pull it up again. Here's the pros and cons:

WSJournal Investing, November 2, 2008
IRAs May Be Ripe For Shift to Roth

One of the simplest ways to take advantage of the continuing market turmoil: Convert your battered investments from a traditional individual retirement account to a Roth IRA.

When you convert traditional IRA assets to a Roth, you have to pay the income taxes upfront on the account's value -- and in some cases, those values may be next to nothing at the moment.

With a Roth IRA, there are generally no taxes on withdrawals or any future earnings, unlike with traditional IRAs. There's also no mandatory distribution schedule -- again in contrast with traditional IRAs, from which account holders must begin taking minimum distributions by April 1 of the year following the year they turn 70 years old. Plus, you can leave a Roth account intact for your heirs. (Heirs other than your spouse would have to take required withdrawals each year, but they generally wouldn't owe any tax on them.)

To be eligible to convert traditional IRA assets to a Roth, your income must be $100,000 or less. So any hit that your paycheck has taken from the economic downturn might help you do a Roth conversion. (Starting in 2010, there is no longer an income limit for Roth conversions.) Neither a required IRA distribution nor the converted amount would count against the $100,000 income limit. If you are 70½ or older, you have to take this year's required distribution before converting any traditional IRA assets to a Roth.

Withdrawal Rules

Many IRA holders get tangled up in the "five-year" rule when they convert IRA assets to a Roth IRA: You have to hold those assets in a Roth for five years or until you turn 59½, whichever comes first, to make penalty-free withdrawals of converted amounts. Each conversion has its own five-year clock.

But if you have already reached age 59½ and you convert traditional IRA assets to a Roth, you can withdraw the actual assets you convert at any time without worrying about a five-year deadline or penalties. It's a different story with any earnings on those assets: Again, you must have held a Roth account for five years to withdraw any earnings tax-free.

But you don't need to worry about separating the converted funds from the earnings; that's because the withdrawal rules for Roth IRAs say that any distributions first come from contributions, then from conversions, and finally from earnings, says Ed Slott, an IRA consultant in Rockville Centre, N.Y.

Chuck Bauer, a 62-year-old manager in Pittsburgh for Aker Solutions, an engineering and construction company, has a combination of market losses and lower-than-normal income this year. So he is taking the advice of a local financial planner, Bud Kahn, and converting his IRA to a Roth, he says.

Mr. Bauer will have to pay about $29,000 in income tax on the conversion, but "we think the account has gone down about $32,000," says Mr. Kahn. "When the account recoups its losses, he will have made up the taxes that he paid. And then that recoupment is never going to be taxed again."

Changing Your Mind

What if you converted traditional IRA assets to a Roth earlier this year, and those assets have declined in value? In that case, you may want to "recharacterize" the Roth as a traditional IRA. It's a way, says Mr. Slott, to "erase the taxes" on value that has since disappeared.

Frank Russo, a 66-year-old Verizon Communications retiree in Port Washington, N.Y., recharacterized IRA investments that he had converted to a Roth after watching their value fall at least 15%. "I don't have to pay tax on an amount that no longer exists," he says.

To do a recharacterization,you have to use a "trustee-to-trustee" transfer, also called a direct rollover or direct transfer, to move the contribution from one IRA to another. Don't touch the money yourself, and make sure no checks get made out directly to you or deposited in your bank account.

The assets are treated as if they never left the traditional IRA, Mr. Slott says. If you recharacterize your Roth as a traditional IRA by Nov. 30, you could then convert the lower-value assets to a Roth again as soon as Jan. 1, he adds.

See IRS Publication 590, at, for information about traditional and Roth IRAs.

    Bookmark   December 12, 2008 at 11:59AM
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Thanks, that was helpful. I will have to sit down and do some serious calculations to figure out exactly what I would be doing I how much it would cost. I know that some of my funds are back down nearly to what I paid for them. I assume that the tax I would pay on the previously-sheltered contributions would be based on this year's income, not that of the year that I made the contribution.

    Bookmark   December 12, 2008 at 2:49PM
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That's correct.

We just did the conversion on my husband's IRA (I did mine a few years ago). The one thing to watch out for is that you want to pay the taxes with money from somewhere else, because if you use money from the IRA, it counts as an early withdrawal, and is subject to the 10 percent penalty.

    Bookmark   December 13, 2008 at 12:19AM
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Great tip, thanks!
I don't quite understand the recharacterization method; the IRS instructions don't really help much when I am thinking about contributions from many years ago (all the examples seem to address current year conversions). Did you rollover or recharacterize?

Either way, would I be paying tax on the original contribution amount plus all capital gains & interest only, or would I be paying on the total current market value of the account (even though any gains in share value are not realized?) Do you recall how it worked for you?

I'd appreciate info from your experience. Don't worry, I won't take action based just on what you tell me!

    Bookmark   December 13, 2008 at 2:08PM
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You're rolling over -- recharacterize is what you do when you do a roll-over and then discover at the end of the year that you didn't actually qualify to rollover. (Or if you roll over early in the year and then prices drop a lot further, you may want to recharacterize.)

And you'll pay taxes on the total current market value of the account (assuming the original contributions were tax-deductible -- if they weren't, you only pay taxes on the increase in value). But then you never need to pay taxes on that account again.

    Bookmark   December 13, 2008 at 6:00PM
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First, watch out when you say that losses in your non-IRA will offset income due to the Roth conversion. The non-IRA losses are capital losses, meaning that you can only deduct $3000/year against ordinary income. The Roth conversion income is in fact ordinary income. Of course, your capital losses will carry over to furture years until burned by capital gains or exhausted $3000 at a time.

Also, I linked a page (below) which has some math formulas that let you compare traditional vs. Roth IRA contribution. It's not as simple as "current tax rate vs. retirement tax rate."

    Bookmark   February 9, 2009 at 7:57AM
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That was an interesting article, but it wouldn't help me very much as I'm totally unable to follow the math equations! So I guess I'd better leave it up to my tax advisor, LOL.

    Bookmark   February 9, 2009 at 10:20AM
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Here is an article that might be useful.

Q: My IRA has lost almost half of its worth this year. How can I claim that loss on my tax return?

A: Nice try, but you can't claim this as a loss. You're thinking of stocks that you sell at a loss; you can claim those as a capital loss on your tax return.

However, there may be a way to capitalize on this ravaging of your retirement account: This may be a good time to consider rolling over your IRA to a Roth IRA. If you had done it a year ago, you would have paid almost double the amount in taxes.

The benefit of a Roth IRA is that you pay taxes on the money now and never again on either your investment or gains. With a traditional IRA, you pay no taxes now on your investment but will pay income taxes later when you withdraw the money.

Note that, for 2008, you're eligible to convert a traditional IRA to a Roth IRA if your tax filing status is single, married filing jointly or head of household. You can file as married filing separately and be eligible. Also, you must have a modified adjusted gross income of $100,000 or less.

If you're eligible, you will have to decide whether a conversion is right for you. One of the other advantages of a Roth IRA: You don't have to take minimum distributions at age 701.2, like you do with traditional IRAs.

But a conversion definitely may make more sense now than it would have a year ago. To walk through the issues to help you decide, go to:

    Bookmark   February 9, 2009 at 12:30PM
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