Roth IRAs Losing Some Converts

Some taxpayers who converted their individual retirement accounts to Roth IRAs last year are racing to reverse the switches because of a variety of surprises, including the unpleasant discovery that they can’t pay the tax bill that the conversion generated.

Taxpayers whose incomes unexpectedly rose above the $100,000 limit for IRA conversions (the cap is the same for single or joint filers), or whose spouses decline to file a joint return, are finding themselves forced to undo the switch. Others are running into a glitch in state law that prevents them from selecting the most advantageous way to figure their taxes. The discrepancy may prompt action from the California Legislature.

Sherman Oaks residents Jeanne Bydlon and Tom Quilling, for example, want to declare as income on their 1998 return all of the $11,000 they converted, rather than spreading the income over four years--the option most often chosen by Roth converters. Federal law allows the couple to include the whole amount in 1998, but so far the state doesn’t.

Bydlon was laid off late last year, and Quilling was in law school, which kept their income low and put them in the 15% federal tax bracket. The couple want to pay the conversion tax bill at that rate, rather than waiting and probably paying a higher rate as their incomes rise.

“He [Quilling] takes the bar this year, and we’re hoping by the grace of God we’ll be making more money” in 1999 and beyond, Bydlon said.

A bill to allow taxpayers to include all the conversion income in one year is making its way through the Legislature and is expected to be passed as early as today.

Affected taxpayers would be smart to delay filing until the bill is passed, said Lynn Freer, president of Spidell Publishing, a tax information service.

Taxpayers whose modified adjusted gross incomes rose above $100,000 last year have no choice; they must undo the conversion by the time they file their taxes. The limit applies to married and single filers. Couples who file separately also are not allowed to convert.

Unlike traditional IRAs, money invested in a Roth IRA isn’t taxed when it is withdrawn in retirement. There also is no requirement that withdrawals be made from a Roth the whole amount, minus any estate taxes, can pass to heirs. Traditional IRAs require minimum distributions after the account holder reaches age 70 1/2. Finally, Roth IRAs are easier to tap than traditional IRAs, and withdrawals often can be made without penalties or added taxes.

No one is sure how many IRAs were converted to Roths--or how many of the conversions have been undone. About 5% of the calls to a hotline operated by Laguna Niguel-based U.S. Tax Systems Inc., which makes software for professional tax preparers, have involved undoing a Roth conversion, said company President Fred Brown. At mutual fund company T. Rowe Price Associates, fewer than 1% of Roth conversions have been undone, while discount brokerage Charles Schwab & Co. has seen “very, very few . . . it’s almost not on the radar,” said spokesman Greg Gable.

Taxpayers who undo a Roth conversion should send the money directly back into a regular IRA, said Gary Trock, an enrolled agent and author of “The Roth IRA Made Simple.”

“The owner of the IRA should never take possession of the funds himself to make the transfer back to the traditional IRA,” Trock said. “This will only disqualify the transaction.”

Taxpayers who must reconvert their Roths to traditional IRAs may still be able to salvage any additional contributions they made to the account, however. Only the portion that was originally converted, plus its earnings, must be returned to a traditional IRA; the 1998 contribution and any earnings (or losses) can stay in the Roth.

If a taxpayer’s income jumped in 1998, however, even the contribution option may be off-limits. Married couples with incomes over $160,000 and singles with incomes over $110,000 are not allowed to contribute to a Roth at all. The ability to contribute to a Roth begins to phase out when adjusted gross reaches $95,000 for singles and $150,000 for couples.

Some taxpayers are finding the tax consequences of Roth conversions are more than they bargained for. Not only must converters pay income tax on the amount converted, but the conversion can boost a taxpayer’s adjusted gross income over the limits for a variety of tax breaks.

Taxpayers whose modified adjusted gross incomes are over $75,000 married or $55,000 single, for instance, are not allowed to deduct student loan interest. Two other education tax breaks, the Hope and Lifetime Learning Credits, disappear when modified adjusted gross incomes exceed $100,000 married and $50,000 single. The $400 dependent child credit begins to disappear for married couples with modified adjusted gross incomes over $110,000 and singles with modified adjusted gross incomes above $75,000.

People who face losing these tax benefits because of a conversion must weigh whether the immediate tax breaks are worth more than the long-term benefit of a Roth, tax experts said.

Typically, the Roth is worth the short-term cost, said U.S. Tax Systems’ Brown, who also educates tax preparers about changes in the tax law. “I think the Roth is the greatest thing since sliced bread for almost anyone,” Brown said.

Despite the advantages, some Roth converters may find they simply do not have the money to pay the tax bill the conversion generated without dipping into the IRA fund itself--a raid that almost always wipes out the advantage.

Rather than undo the whole conversion, tax experts recommend leaving at least part of the money in the Roth. If a taxpayer who originally converted $100,000 decides that she can only afford to pay taxes on a $20,000 conversion, for example, 80% of the current value of the Roth should be sent back to the traditional IRA. That salvages some of the benefits of the conversion and reduces the tax bill.

Roth conversions also can create worries about withholding penalties.

David Miller, a mechanical engineering professor at Cal Poly Pomona, discovered after doing his taxes this year that he would owe the IRS about $6,000, much of it due to the $60,000 IRA he converted to a Roth on Dec. 31. People who owe the IRS more than $1,000 can be subject to penalties for inadequate withholding.

But fortunately for Miller, taxpayers whose 1998 withholding at least equaled their 1997 tax bill can generally escape the penalties. Either way, Miller said he is glad he converted.

“I hate to have to pay the taxes, but I would hate it even more when I’m retired,” Miller said. “I can afford it now, and it will give me a lot of flexibility later.”

For more information on Roth IRAs, visit https://www.latimes.com/HOME/BUSINESS/INVEST101.

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Roth Traps

As the tax deadline nears, some savers are scrambling to undo their 1998 Roth IRA conversions. Among the main reasons:

* Their income unexpectedly rose above the $100,000 ceiling for Roth conversions. The limit is the same for single and joint filers.

* They can’t pay the tax bill the conversion generated.

* Their spouse declined to file a joint return.

* A glitch in state law prevents them from selecting the most advantageous way to compute their taxes.