Reconvert your traditional IRA to a Roth … with restrictions

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in Leaders & Managers,Management Training

Suppose you converted your IRA to a Roth IRA just before the bottom fell out of the stock market. Based on the inflated value of the account on the conversion date, you were staring down the barrel of a tax disaster.

So you followed our timely tax advice and recharacterized your Roth to a traditional IRA (see Undo tax damage on Roth IRA conversions).

But now you see signs of a market rebound. And you’d like to take advantage of the Roth IRA setup for all the same reasons that attracted you to it in the first place.

Strategy: Reconvert your IRA. In other words, convert your recharacterized traditional IRA back into a Roth IRA. This is treated as a new conversion for tax purposes.

However, the IRS doesn’t allow you to keep flip-flopping between the two types of IRAs without any limitations. You must meet specific time restrictions for a reconversion.

Here’s the drill: With a Roth IRA in existence at least five years, qualified distributions are completely exempt from federal income tax. A qualified distribution is one that is:

  • Paid after reaching age 59½
  • Received on account of death or disability
  • Used for first-time homebuyer expenses (up to a lifetime limit of $10,000).

In contrast, traditional IRA distributions are taxed at ordinary income rates as high as 35%—probably even higher in future years.

Currently, you can convert a traditional IRA into a Roth only in a year in which your adjusted gross income (AGI) doesn’t exceed $100,000(see box below). The tax on the conversion is based on your account balance on the last day of the previous year.

Example: You’re in the 25% tax bracket and you converted your IRA into a Roth in 2008. Based on its value of $100,000 on the conversion date, your tax liability for the conversion was $25,000.

But then the value of the assets plummeted to $60,000 at the end of last year. By recharacterizing your Roth back into a traditional IRA early in 2009, you wiped the $25,000 tax bill off the books.

Now let’s say the assets are still worth $60,000. If you reconvert the IRA back into a Roth when it is based on a $60,000 value, you’ll pay $15,000 in tax—a $10,000 tax savings.

Be aware that a traditional IRA can’t be reconverted back into a Roth before the later of:

  • The beginning of the tax year following the tax year of the original conversion into a Roth IRA
  • The end of the 30-day period beginning on the day of the recharacterization back to traditional IRA status.

Tip: In our example, that means you can convert back to a Roth now, if you want. The tax rule gives you plenty of flexibility.

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