August 15, 2008

Roth IRA conversion in a bear market

Good article over at Yahoo Finance related to the conversion of a traditional IRA to a Roth IRA during bear markets.

With the market down about 12% since January 1, there are probably thousands of people who converted from a traditional IRA to a Roth IRA this year, and have now lost value in their accounts. If you're a long term investor, no problem right? Wrong. The issue is that you now owe taxes on the converted amount, which is higher then the amount transferred. In some cases, this amount can be substantial.

For instance, let's say you converted $200,000 on January 1. The tax owed on this conversion (assuming you are in the 28% bracket) is $56,000. Now let's say that your account is only worth $176,000. You still owe tax on the $24,000 of lost value, or approximately $7,000.

Not so fast though. The article highlights a lessor known IRS rule called "recharacterization". Basically, recharacterization is a do over. It allows an individual to return the money to the traditional IRA and no tax is due. The individual can then convert back to the Roth IRA at a later date.

There are some date restrictions on this rule -

  • You have up to 6 months after the due date of your 2008 return to undo the conversion (October 15, 2009 for most individuals)
  • You must then wait until the following year or 30 days after the initial conversion (which ever is later) to reconvert

So should you recharacterize? Depends. The issue is related to where the market will be at year-end. If you recharacterize now, you need to wait until at least 1/1/2009 to reconvert. If the market climbs higher and ends above the January 1 level, then recharacterization does not make sense since you will end up owing more taxes. If however, the market decreases, recharacterization makes sense since less taxes are owed.

Bottom line is you have time to see where the market goes between now and year-end. If it continues to decline, hold off and recharacterize right at year-end and reconvert in 2009. If the market climbs and ends higher then where you originally converted, you don't need to do anything, since you will pay the least amount of taxes possible.

This area is a bit complex and you should ensure you consult with your accountant and attorney before completing any transactions.