IRA Drop in Value? Consider Roth Transfer

Do you have stocks tucked away in a traditional individual retirement account that have the potential to be winners but currently are money losers? If so, it may be time to transfer them to a Roth IRA.

"It's almost like a half-off sale," said Ed Slott, a New York tax accountant who writes a retirement newsletter called the IRA Advisor. "If your IRA has dropped significantly in value, not only will the cost [of converting to a Roth IRA] be minimal, all the upside would be tax-free. Now is the time to strike."

When taxpayers transfer assets from a traditional IRA to a Roth IRA, they must pay income tax on the transferred amount. The tax can be as much as 30% to 50% of the amount transferred--high enough that few of the 33 million individuals with traditional IRAs have converted them to Roth IRAs, according to retirement planning experts. Some people also can't convert because their earned income is too high. Tax law bars anyone who earns more than $100,000 annually--married or single--from converting a traditional IRA to a Roth.

However, for those who can do it, the benefits of converting to a Roth IRA can be significant, especially for those with either a lot of savings or a long time horizon, Slott said.

The reasons lie in the differences between the two types of IRAs.

Money contributed to a traditional IRA can be deducted from that year's taxable income. But the money is taxed at the account holder's ordinary income tax rate when it's withdrawn during retirement.

In contrast, a Roth IRA doesn't provide an upfront tax deduction. But when the money is withdrawn in retirement, all the investment gains are tax-free.


Conversion Can Benefit Younger Workers

Another key difference: IRA owners are required by law to start withdrawing money from their accounts by age 70.5. Roth IRAs have no such withdrawal requirements. Seniors may leave their Roth IRA money alone indefinitely, which saves wealthy retirees from paying income tax on mandatory withdrawals that they neither need nor want.

Roth IRAs also can be left to heirs without the tax consequences that afflict traditional IRAs.

Young workers, who usually are in low tax brackets, can benefit from converting IRA assets into a Roth, experts said. That's mainly because workers who save prodigiously when they're young tend to have a lot of money--and be in higher tax brackets--when they're old. That boosts the value of tax-free income in the future.

Still, it makes no sense to convert now if you can't afford to pay the tax, Slott said. You can't use the withdrawn IRA assets to pay the tax without triggering penalties of 10% of the withdrawn amount, which would make the deal uneconomical.

But there's an option that some investors may not have considered: Transfer only the securities that have lost the most value, and don't transfer more than you can afford to pay tax on. Also--and this is a key point--transfer securities that you believe have the potential to rise substantially in value.

"The logic [of doing partial conversions] is most compelling on the stuff that's fallen in value and is likely to come back," said Phil Holthouse, partner in Los Angeles tax law and accounting firm Holthouse Carlin & Van Trigt.


A Portion of Traditional IRA Can Be Transferred

Consider an investor who owns 1,000 shares of a tech stock in a traditional IRA. The shares once sold for $50 each but now are $5, and the investor is convinced that the stock is underpriced.

If the 1,000 shares were transferred to a Roth IRA, they'd be taxed at the investor's ordinary income tax rate at their current market value of $5,000. Assuming the investor is in the 30% bracket, the tax bill would be $1,500.

If the stock rebounds to $50 a share--a total of $50,000--moving the shares into the Roth would save this investor $13,500 in income taxes over time. Why? Because the investor won't owe any tax on the $45,000 gain that occurred after the shares were transferred to the Roth IRA.

Remember, you don't have to convert the entire IRA. A portion can be converted by transferring only specific shares or a set percentage of the account's assets. If you convert half of an IRA, for example, instead of having one IRA worth, say, $10,000, you'd have two worth $5,000 each.

"You can cherry pick," Slott said. "Maybe all you want to do is convert your IBM shares."

The only drawback to breaking IRA assets into separate accounts is that most banks, brokerage and mutual fund companies that serve as IRA custodians charge a nominal annual fee--from $10 to $40--to open and maintain the account. (You can have as many IRA accounts as you like--Roth or traditional--but your contributions are limited to a total of $2,000 for all IRAs for the 2001 tax year. The amount will go up next year.)

Many people prefer having a single IRA to avoid additional account maintenance fees, Slott said. But there are some practical estate-planning benefits to having more than one account, he said.

For instance, IRA assets can bypass probate and go directly to heirs if the account holder designates a beneficiary for the account. Certainly, more than one beneficiary can be designated on a single account. But it's sometimes simpler and less contentious for the account holder to break the assets into separate IRAs, designating a single beneficiary for each, he said.

Still, the biggest benefit may be that splitting IRA assets into separate accounts allows taxpayers to transfer some of their IRA assets into a Roth IRA without incurring a big tax bill.

What do you do if you regret converting these assets later? The IRS gives you several months to change your mind and put back the money, Slott said.

Taxpayers who do IRA conversions before Dec. 31 will have to report the converted amount on their 2001 tax returns and pay any tax that's due, Slott noted. Taxpayers who opt to undo conversions after paying the tax must file amended returns before Oct. 15, notifying the government that they've put the IRA money back where it was. The IRS will then refund the tax overpayment.