Readjusting Your Stocks to Save on Taxes

A second way to establish a Roth IRA is by converting a traditional IRA or a former employer's retirement plan if you meet the income limit and you're not a married person filing a tax return separate from your spouse. But there's a tax bill associated with that conversion and that's why many investors who converted to a Roth this year will want to consider recharacterizing back to a traditional IRA.

Related

Movement to Scrap 401(k)s Gains Traction

Is It Time to Get Back Into the Market?

Is Your Money Market Safe?

In my example above, a $20,000 conversion to a Roth IRA triggers income tax on $20,000 in income even if the account now is worth just $12,000. The taxable amount is based on the account's value as of the day of the conversion, not its value at the end of the tax year.

There's still plenty of time to recharacterize a Roth that has gone down in value. The deadline for a recharacterization is the date on which your tax return for a given year is due. Normally, that's April 15 of the year after the conversion, but the deadline can be stretched to Oct. 15 with properly filed extensions.

Now, however, is a good time to consider recharacterizing a Roth IRA. If you do it before the end of the year, you will be eligible soon to do second conversion to a Roth at a lower cost.

To reconvert back to a second Roth IRA, you normally must wait at least 30 days and until the following tax year. That means if you wait until April 2009 to do your recharacterization, then you can't reconvert that amount back to a second Roth IRA until 2010.

But if you do the recharacterization during December, you will able to convert back to the second Roth IRA in January after waiting at least 30 days from the date of the recharacterization.

Using my earlier example, you'd pay income taxes on a $12,000 conversion instead of the earlier $20,000 conversion. For a taxpayer in the 25-percent tax bracket, that would amount to a tax savings of $2,000 and still capture tax-free withdrawals.

For details on how to carry out a recharacterization, you should consult IRS Publication 590. I'd also suggest seeing a tax advisor for larger amounts or at least utilizing tax preparation software to be sure the recharacterization is reported properly.