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Get Your IRS Freebie by October 17th


Losing money in the stock market is never fun, but what’s worse is having to pay tax on the lost market value. In 2010, the IRS changed the rules to allow anyone, regardless of their income, to convert an old 401k or a Traditional IRA to a Roth IRA, as long as they pay the tax on the converted value. Many people in the “higher” income brackets have taken advantage of this window of opportunity to gain access to the coveted Roth IRA, which is not available to high income earners. Even though investors have to pay tax on the converted value, they can side-step the mandatory Required Minimum Distribution rules, and enjoy many other advantages specific to the Roth IRA such as tax-free investment growth. Although the investors who converted to a Roth IRA were smart in doing so, unfortunately, they saw the value of their new Roth IRAs decline as the economy weakened. The even more unfortunate part is that they owed taxes on a much higher account value. If you were one of these investors, you may feel like you’re stuck having to pay tax on the originally converted amount, however, there is good news! What many people don’t realize is that the IRS allows investors to “undo” a Roth IRA conversion, by October 17, 2011, without penalty in what is known as a recharacterization.

Let’s take a closer look. Assume that in 2010 you converted your Traditional IRA (worth $100,000) into a Roth IRA; you would have to recognize and pay tax on $100,000 in income for 2010. If you are in the 25 percent tax bracket, that means you would owe $25,000 in taxes. Let us assume further that given the recent market volatility, your account is now worth $80,000, though you still owe taxes on the original $100,000. However, if you take advantage of the IRS allowed recharacterization and convert your Roth IRA back to a Traditional IRA, you can undo the original conversion and not owe any taxes. Worried that you won’t be able to reap the benefits of the Roth IRA in the future?  Don’t worry. After the later of a 30-day waiting period or January 1st of the year following your original conversion, you can always convert back to a Roth IRA. Assuming the value stays at $80,000 when you decide to convert back to the Roth IRA, you would then owe $20,000 (25 percent of $80,000) instead of the original $25,000, for a nice savings of $5,000. If you have already filed and paid your 2010 taxes, you can file an amended return and claim a refund for the excess taxes you paid.

The conversion process is fairly simple, but you must remember to file by the deadline. To initiate a Roth IRA recharacterization, you must submit paperwork to your custodian (the brokerage that holds your accounts, i.e. Scottrade) of your intention by October 17, 2011 to undo a 2010 conversion. If you rolled over from a previous employer’s 401k into a Roth IRA, you can still recharacterize, but you must transfer the Roth IRA assets to a new or existing Traditional IRA, not back into the original 401k plan.

Ara Oghoorian, CFA, CFP® is the president and founder of ACap Asset Management, Inc., a “Fee-Only” financial advisory and investment management firm located in Los Angeles, CA. Contact Ara at aoghoorian@acapam.com or on the web at www.acapam.com for a complimentary consultation.