There’s still a chance for a do-over for some retirement savers, but time is running out. Investors who took advantage of a law that allowed them to convert a traditional Individual Retirement Account to a Roth IRA last year can still change their minds — and some might want to if recent stock market declines have hit hard or if their personal finances have declined.
The deadline for undoing a 2010 conversion is Oct. 17. Taxpayers who already filed a federal income tax return for last year will have to file an amended return if they undo the conversion.
The tax code change related to Roth IRA conversions is permanent, but the IRS gave taxpayers who converted in 2010 a one-time special advantage of spreading out the tax payment to 2011 and 2012.
Withdrawals from traditional IRAs are taxed as ordinary income when the account owner reaches retirement age, while withdrawals from Roth IRAs are exempt from taxation.
The flip side is that contributions to a traditional IRA are deducted from the saver’s income taxes and are allowed to grow tax-free during the accumulation stage. Roth IRA investors do not get that deduction.
The law that allowed retirement savers to convert traditional IRAs to Roth IRAs also provided a loophole to undo, or recharacterize, the conversion by Oct. 17, if the portfolio’s value were to drop substantially at the beginning of 2011. This was to prevent owners of the newly converted Roth from paying taxes on money that had been lost.
Stock markets have been in retreat this year as more money has raced to the sidelines. According to the Investment Company Institute, investors have pulled $75 billion out of U.S. equity funds since April 30 — more than the amount that left the stock market in the five months after the 2008 Lehman Brothers collapse.
Another possible reason to undo a conversion, said Howard Davis, president of the Davis, Davis and Associates accounting firm in Pittsburgh, is if an investor’s financial condition has changed, and he or she either cannot or does not want to pay the tax.
For example, someone in the 35 percent tax bracket who converted a traditional IRA valued at $100,000 to a Roth IRA would owe $35,000 in taxes. Half of the bill — $17,500 — is due in 2011. The other half would be due next year.
“Even if you’ve already paid the whole tax bill upfront or a portion of it, you can file an amended return and get the money back,” Davis said.
The most common reason for recharacterizing a Roth IRA, however, is because of lost value in the retirement portfolio, said Greg Womack, of Womack Investment Advisers in Edmond, Okla.
Assume an investor converted a $100,000 traditional IRA to a Roth IRA in May, Womack said. Then, by December, the Roth IRA has lost 40 percent of its value and is worth only $60,000. The investor still would be required to pay income taxes based on the conversion date value of $100,000.
“The amount of income tax … is based on the value of your IRA on the date you converted it. Therefore, you may want to recharacterize your contribution to a traditional IRA if your Roth IRA decreases in value after the conversion date.”
