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A ‘do over’ on your IRA conversion

Question: Now that the stocks in my IRA have taken a big hit, does it make sense for me to convert to a Roth IRA? I anticipate retiring in about 10 years. —Scott Bottorf, Johnston, Iowa

Answer: The decision to convert an IRA or 401(k) to a Roth IRA should be based on your overall finances today and your retirement prospects for the future (including an assessment of the tax hit you may face after retiring), not the level of the stock market at any given moment.

So, no, you shouldn’t convert to a Roth IRA just because stock prices have fallen.

Similarly, I don’t think it makes sense to try to time a conversion to coincide with a market decline. Granted, you’ll shell out less in tax if you manage to convert your IRA when its balance is lower rather than higher. But the way things have been going lately, it’s entirely possible that the market could fall farther from here, in which case you would have been better off waiting even longer to switch to a Roth. You can’t win this sort of guessing game.

That said, if you believe that converting some or all of your IRA to a Roth IRA does make financial sense you may want to consider converting before the end of the year.

Why? Well, you’ll be well-positioned to take advantage of a little-known “do over” provision in the Roth regulations that could help you lower your conversion tax bill if the market drops after you convert.

Oh, and if you’re in the unfortunate position of having converted to a Roth IRA earlier this year before the market fell apart – in which case your conversion tax bill may be higher than it would have been had you held off converting until after stock prices had fallen – you may be able to use the same “mulligan” rule to undo and then re-do your conversion and save yourself a bundle in taxes.

Do over

The technical term for it is a “recharacterization.” Basically, if you have converted money in a traditional IRA or 401(k) to a Roth IRA, a recharacterization allows you to undo the conversion and return the money (plus investment earnings, if any) to a traditional IRA. It’s as if the conversion never happened. The neat part is that you can then reconvert to a Roth IRA later on, if you wish.

Of course, as with anything related to taxes and retirement accounts, there are a few rules you’ve got to follow to get this second chance. You can recharacterize a conversion any time up to the income tax filing deadline with extensions for the tax year of the conversion. So if you convert in the 2008 tax year, you can recharacterize as late as October 15, 2009.

If you want to convert back to a Roth again, you must wait at least until the year after your original conversion (so 2009 or later if you converted in 2008) and your re-conversion must be at least 31 days after the recharacterization. Finally, you must still meet the conversion eligibility rules when you reconvert.

So how can this “do over” work to your favor if you convert to a Roth IRA now?

Well, let’s say you’re in the 25% tax bracket and you’ve got an IRA that had a $150,000 balance at the beginning of the year that has since fallen to $100,000. You’ve also decided that a conversion makes financial sense for you. And although you can’t take credit for planning it this way, you like the fact that if you convert your IRA at today’s depressed stock prices, you’ll have to come up with $25,000 to pay the conversion tax bill instead of the $37,500 you would have had to fork over had you made the switch when your IRA was worth $150,000.

By doing the conversion before the end of the year, you also lock in the right to re-do the conversion in 2009. That can be nice option if the market continues to slide.

For example, let’s assume you convert between now and the end of the year and the market plummets again in early 2009, knocking down your Roth IRA balance to $80,000. You could recharacterize, move the $80,000 back to an IRA and then reconvert after waiting 31 days. (For that matter, if the market dives again this year, you could recharacterize this year and then reconvert anytime in 2009, assuming at least 31 days have passed since your recharcterization.) If your IRA balance is still $80,000 when you reconvert, you would pay $20,000 in tax instead of the $25,000 for your original conversion, a tidy $5,000 savings.

Of course, you do take the risk that the market could recover after you recharacterize, pushing your account balance back to its original value or higher before you can re-convert. Were that to happen, you could owe more in tax than you would have paid for your original conversion. But you can reduce that possibility by keeping the period between your recharacterization and reconversion as short as legally possible.

Which is why you might want to convert in 2008. If you hold off until next year, you would still have the right to recharacterize and undo your conversion in the event of a market decline. But since you can’t re-convert the same year of your original conversion, converting in 2009 would mean you would have to wait until 2010 to reconvert. That increases the chance that the market might rebound and that you could face a higher tax bill.

So if you believe you’re a good candidate for a Roth conversion and you would at least like to have the option of reconverting next year in the event the market continues to slide, you may want to get that conversion in before the end of the year.

Ah, but what if you’ve already converted to a Roth this year before the market fell apart? Well, you can also use the “mulligan” rule to undo your original conversion and possibly shave your tax bill. Just as in the example above, you would recharacterize, move the money back to a traditional IRA and then reconvert to a Roth in 2009 (and after waiting at least 31 days from the recharacterization). Assuming your traditional IRA’s balance hasn’t rebounded back to its level when you originally converted – and that you haven’t moved into a higher tax bracket – your tax bill will be smaller than it was with the original conversion.

Tax considerations

Clearly, taxes are a major factor in deciding whether to convert to a Roth (or re-convert, for that matter). The reason is that by converting to a Roth IRA, you pay income tax on the taxable portion of your traditional IRA today rather than postponing that hit until retirement. So, generally, it’s worthwhile to convert only if you expect the tax rate you’ll face in retirement will be the same or higher than your rate at the time of your conversion.

Taxes are always a bit of a wildcard. And now that a new president who made sweeping tax changes a major part of his campaign will be taking office in January, the tax picture is even more uncertain.

For example, while stumping for the presidency, candidate Obama said he would eliminate taxes for seniors making less than $50,000 a year. It’s anyone’s guess whether this provision will make its way into law and how it would actually work if it does. (Will all income qualify for the exemption or just earned income? How will income above $50,000 be taxed?) But if you’re nearing retirement, it raises at least the possibility that converting to a Roth IRA could be a bad deal since you would pay tax on traditional IRA dollars you might able to withdraw free of tax.

You certainly don’t want to be changing your retirement planning on the basis of every tax proposal that’s floated in DC. You would be in a state of perpetual motion, and have no coherent strategy. Besides, when it comes to the issue of tax-free Roth accounts vs. tax-deferred IRAs and 401(k)s, the very fact that tax policy can change so often suggests that it’s a good idea to have at least some money in a Roth account as well as traditional IRAs and 401(k)s to diversify your tax exposure in retirement.

But given the new administration and shift in the makeup of Congress, you definitely want to stay alert to possible changes in the tax laws that may affect your decision to convert.

And above all, remember: if you do convert but later think better of it, at least you’ll have a shot at reversing the decision.

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