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Undo tax damage on Roth IRA conversions

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Say you converted your traditional IRA into a Roth IRA earlier in the year. Once you absorb the current tax hit, future distributions from the Roth after age 59½ will be completely tax-free after five years.

But the value of those retirement funds may have plummeted recently. Worst of all: The tax liability for the conversion is based on the value of your account on the conversion date.   

Strategy: Convert your Roth IRA back to a traditional IRA. That way, you’re not taxed on the higher value of the account at the time of the conversion. There’s no tax due on this “recharacterization.”

The deadline for undoing a 2008 Roth IRA conversion is Oct. 15, 2009.

How much can you save with a recharacterization? Plenty. Let’s say your IRA was worth $250,000 when you converted it on Jan. 2. All of the funds consisted of deductible contributions and earnings.  If you’re in the 35% tax bracket, the conversion would cost you $87,500 in income tax (35% of $250,000). That massive tax bill is wiped off the books.

Suppose you convert back to a Roth again in 2009 (a “reconversion”). At that time, your account is worth $150,000, so the tax on the reconversion is $52,500 (35% of $150,000). This clever tax gambit still saves you $35,000 ($87,500 minus $52,500).         

Note that a traditional IRA can’t be reconverted back to a Roth IRA before the later of:

  • The beginning of the tax year following the tax year of the conversion or
  • The end of the 30-day period beginning on the day of the recharacterization back to traditional IRA status. This rule applies regardless of whether the reconversion falls into the year of the conversion or the following year.

A better day coming: Currently, you can convert a traditional IRA to a Roth IRA only in a year in which your AGI is $100,000 or less. But this dollar cap will be removed in 2010. If you convert or reconvert a traditional IRA to a Roth in 2010, the resulting tax liability is spread out over the next two years—2011 and 2012.

Tip: Besides a declining value, you might also recharacterize a Roth IRA back to traditional IRA status if you believe your AGI for 2008 will exceed $100,000.

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