U.S. Extends Time to Revert Roths to Old IRAs

Converting a regular individual retirement account to a tax-free Roth IRA seemed like a great idea a year ago, but it caused problems for tens of thousands of people, so the IRS is taking the unusual step of giving them until Dec. 31 to switch the money back to their old IRAs.

Normally, the second income tax extension period would have ended Oct. 15. But the IRS said many of those who converted their IRAs to Roths found out they were ineligible because their incomes exceeded IRS limits or because they were married but filing their taxes separately.

The IRS is sending out letters to 20,000 taxpayers who appear to be ineligible. The tax penalties are harsh, it said, thus the added time.

But the IRS announcement was so broad that it also will allow many other people to switch back--those whose only problem is that the value of the mutual funds or stocks they moved into their IRAs declined.

The process, called “re-characterization,” might be valuable to those who may have transferred, say, $100,000 in securities from a regular IRA into a Roth for the tax advantages, only to find the volatile stock market has slashed the value of those shares--but they still owe taxes on the original $100,000. Until Dec. 31, those people can put the securities back in their original IRA. That sounds like an easy decision, but it might not be.

Let’s step back for a moment and see how we got into this mess. The Roth IRA was hailed when it was approved in 1997 because it would allow people to put money in an IRA that could be withdrawn with all profits tax-free after it had been in the account at least five years and when the individual was over 59 1/2. With a regular IRA, your distributions are taxed. There were income limits--up to $160,000 for a couple filing jointly--but you could open a new Roth IRA until April 15 of the following year, as with any IRA.

The law also allowed those with incomes of less than $100,000 to convert their old IRAs to a Roth. Couples filing separately could not do so because of the government’s fear that there might be underhanded income-shifting that would allow both to convert to Roth IRAs when, if they filed jointly, their income might make them ineligible.

But the real problem was the date. A conversion had to be done by Dec. 31, not April 15. In other words, before people filed their income tax. Many people who get bonuses or commission at the end of the year had their final income in doubt but still had to make conversion decisions before they knew.

But there wouldn’t have been a problem with income in the first place if the original bill writers had had their way, a Senate aide said. “We came in originally with no income limits, so the problem wouldn’t have occurred. But we couldn’t get it through.” But, he said, the chances of getting a bill through this year are slim. He added that there was no chance the IRS or the Treasury Department would switch the conversion date to April 15, which other sources confirmed.

So, what about the decision to re-characterize? If you were not eligible to convert your IRA but did anyway, re-characterizing is important, because you could have to pay “both regular and early distribution taxes on the amounts involved,” the IRS said. That early distribution tax is the 10% penalty.

You also will have to amend your 1998 tax return if you re-characterize so you get back the taxes you paid. You have three years to do that, but why lend the government your money?

On the other hand, some people whose stocks have fallen slightly might not want to switch back, in the hope that their investments will still provide the good long-term returns they bought them for in the first place.

Others might want to keep the four-year tax spread. But Alan Weiner, a partner at Holtz Rubinstein in Melville, N.Y., said, “You get the same effect by converting 25% of your money at a time,” because the money in the old IRA would still be growing tax-free also.

At any rate, everyone who converted an IRA should check to make sure they were eligible. If you were married and living together but filing separately, you weren’t.

If you are planning to convert this year, and your yearly income is uncertain but likely to be on the borderline, you might give some thought to whether you want to go through this again.