Holders of Converted IRAs Need to Act Fast for Tax Break
If you converted an individual retirement account to a Roth IRA in 2001, the stock market’s rotten performance this year may be a tax break in the making.
But only if you act fast.
IRA owners who converted to a Roth IRA last year, and then watched the value of the account collapse along with the stock market, have until Oct. 15 to reverse--or “recharacterize”--the transaction.
That won’t restore the losses in the account, of course. But it will allow the account holder to recoup income tax paid on investment gains that have since disappeared.
“It’s one of the few second chances offered by the tax code,” said Ed Slott, a New York-based tax accountant and editor of a monthly newsletter on individual retirement accounts. “It’s kind of like getting to bet on a horse race after it’s run.”
Thousands of Americans have converted their traditional IRAs to Roth IRAs in recent years, largely because Roth accounts--created by Congress in 1997--often are seen as the better deal, tax-wise.
Roth accounts offer no upfront tax breaks, but the money--what the account holder contributes as well as any investment gains--is withdrawn tax-free during retirement.
A traditional IRA, by contrast, offers an upfront tax deduction but the money is fully taxable when withdrawn.
Transfer Triggers Tax
The downside: When you shift investment assets from a traditional IRA into a Roth IRA, you owe taxes on the value of the account at the time it’s converted. And the tax is figured at your ordinary income tax rate--not the long-term capital gains rate, which usually is lower.
The tax is triggered regardless of whether the investments within the IRA are sold or transferred to the Roth account. The taxable income on the transaction is based on the market price of the securities held in the IRA at the time of the conversion.
For many taxpayers who did conversions in the last two years, paying current-year taxes on income that remains locked in a retirement account was made worse by the falling stock market, which probably wiped out a sizable portion of the gains on which they were paying taxes.
Consider the plight of one of Slott’s clients. His IRA was converted to a Roth when it was worth $75,000. It’s worth $1,000 today. A taxpayer in this situation could recover roughly $23,250 in 2001 income tax--assuming a 31% federal income tax bracket--if he opts to reverse the conversion.
It’s too late to undo a conversion that was performed before 2001. But savers who converted an IRA last year have until the final filing deadline for the 2001 tax year--Oct. 15--to undo the conversion by shifting the money from the Roth IRA back into a traditional IRA, Slott said.
Some taxpayers believe that they can’t undo a conversion if they’ve already filed a 2001 tax return, Slott said. But all that’s required in these situations is that the taxpayer file an amended return--Form 1040X--and subtract the income previously reported from the IRA conversion, said Don Roberts, a spokesman for the Internal Revenue Service in Washington.
For instance, Slott’s client would subtract $75,000 from the pension income reported on his 2001 return, claiming a $23,250 tax overpayment on the 1040X. Taxpayers who file a 1040X can either ask for a refund of the tax they paid on the conversion or have it applied to their 2002 taxes, which will be due April 15.
An added attraction is that the IRA can be converted back to a Roth IRA later. But under tax rules, the new conversion can’t be performed until the next calendar year following the conversion--2002--or 30 days from the date the account was recharacterized, whichever is longer, said Roberts.
For Information
Several Web sites offer information on IRA conversions, including www.rothira.com and www.fairmark.com/rothira. Most borkerage firm Web sites have IRA info, and the IRS’ Publication 590, which provides tax info on retirement plans, is available at www.irs.gov.
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