Market Plunge Gives Roth IRAs New Currency


If you were wavering about whether to convert your traditional individual retirement account to a Roth IRA, you might want to make up your mind soon.

The recent plunge in the stock market means that if you decide to convert now, you could wind up paying a lot less in taxes than you would have earlier this year.

Furthermore, people who have already switched might want to consider undoing their previous conversion and then convert again, if their accounts have lost sufficient value in the interim.

"For a little paperwork, [IRA investors] can save thousands of dollars," said Steve Norwitz, resident Roth IRA expert at T. Rowe Price mutual fund company.

What's more, there seems to be no limit on the number of conversions allowed, meaning a taxpayer could repeatedly undo and reconvert an account if the market continues to fall. If the market starts to soar, however, then the opportunity to reduce your conversion taxes might be lost.

Like almost everything else involving Roth IRAs and taxes in general, the rules are complex and people may need professional advice. Experts say the complexity is part of the reason that banks and brokerages are seeing fewer Roth conversions than they expected.

"Once people look into it, [many decide:] 'This isn't as good as it sounded,' " said Judith Golden, spokeswoman for the IRS' regional headquarters in Laguna Niguel.

For those new to Roths, some background: Roth IRAs were created as part of the 1997 Taxpayer Relief Act to enable more people to save tax-deferred income for retirement. Unlike some traditional IRAs, contributions to a Roth IRA are not tax-deductible. But money invested in a Roth IRA is not taxed when you withdraw it in retirement; most of the money in a traditional IRA will be taxed at ordinary income tax rates. Also unlike traditional IRAs, there is no requirement that you must start taking withdrawals from a Roth IRA after age 70 1/2, and the entire amount, minus any estate taxes due, can be passed to your heirs. Roth IRAs are easier to tap than traditional IRAs. In fact, withdrawals can often be made without paying penalties or additional taxes.

Working people with incomes under $160,000 (for married couples) or $110,000 (for singles) can contribute up to $2,000 in earned income to a Roth. Singles or couples who make less than $100,000 can also convert an existing traditional IRA to a Roth IRA to take advantage of the Roth's special tax status.

Converting your traditional IRA, however, means paying income taxes--perhaps on the entire amount. Only the amount of your non-deductible contributions escapes tax; all deductible contributions and earnings get taxed at your state and federal tax rates.

To ease the financial burden, the law allows you to spread this taxable income over your next four annual tax returns. But you have to convert by Dec. 31 of this year to get this deal.

Brokerages, mutual fund companies and banks say the new Roth IRA has been popular with investors. Fidelity Investments in Boston says the number of IRAs opened at the company has jumped 150% compared with last year, thanks largely to people starting new Roth IRAs and converting their traditional IRAs.

Still, many companies say conversions of traditional IRAs to Roth IRAs have been trailing their expectations. Some, including Vanguard, expect conversions to surge at the end of the year as the Dec. 31 deadline approaches. Others say investors whose incomes were close to the $100,000 mark were worried that the conversions would not be reversible if they went over the income limit, which would have left them with a big tax bill and no Roth benefit.

To make the decision easier, Congress passed a bill earlier this year that allows taxpayers to undo a conversion. But Congress placed no limit on the number of times a taxpayer could undo and redo a conversion, opening the possibility that investors could try to time the market to reduce their tax bill.

Here's an example: Let's say an investor converts a $50,000 traditional IRA invested in Vanguard Index 500 fund, a mutual fund that mimics the Standard & Poor's 500-stock index, to a Roth IRA at the peak of the market in July. Assuming the investor was in the 28% federal and 7% state income tax brackets, the tax bill for the conversion would be $17,500.

But if the investor waited until Wednesday to convert, or redid a previous conversion, the value of the investment would have declined more than 13%, to $43,215. That reduces the tax bill to $15,125, or $2,375 less.

If the market falls an additional 10% by the end of the year, the taxpayer could redo the conversion, and save an additional $1,500.

The practical benefit is limited to people who have most of their money invested in the stock market, because bond and certificate of deposit investors have seen their IRAs increase in value in recent months.

Taxpayers can continue redoing their conversions up until their tax returns are due in 1999, although they will lose the ability to spread the tax bill over four years if they undo the conversion after Jan. 1, the IRS' Golden said.

And while Congress has placed no limit yet on conversions, that could change. Officials at the Treasury Department reportedly are monitoring the trend, and may act to limit conversions. Some investment companies are also considering limits.

"Operationally it's expensive for us to do it, and we don't get any benefit," T. Rowe Price's Norwitz said.


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* PROS and CONS: Should you convert an existing IRA to a Roth IRA? D4

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