If you converted your individual retirement account to a Roth last year, you probably feel like someone who got married during a weekend in Vegas. It seemed like a good idea at the time, but now you're having serious second thoughts.
When you convert to a Roth, you're required to pay taxes on all pretax contributions and gains. The taxes are based on the value of your IRA at the time of the conversion. That makes an IRA conversion a smart move in a bear market — unless the market continues to plummet after you convert. When that happens, you could end up paying taxes on money you no longer possess.
For example, suppose you converted an IRA valued at $100,000 last spring. On April 15, you'll owe taxes on $100,000, even if your Roth is now worth less than half that amount.
Fortunately, reversing an ill-timed IRA conversion is a lot easier — and less expensive — than getting out of a madcap marriage.
You can undo the damage by "recharacterizing" your Roth. That process turns your Roth back into a traditional IRA, wiping out your tax bill.
If you don't think you can get the job done by Wednesday, you can buy yourself some time by filing for a six-month extension to file your 2008 tax return, says Barry Picker, an accountant and financial planner in Brooklyn, N.Y. After you recharacterize, you can file your tax return, and you won't owe taxes on the conversion, he says.
Just make sure you recharacterize by Oct. 15, which is the deadline for reversing IRAs converted in 2008. Otherwise, you'll be subject to steep penalties.
Back to the future
Recharacterizing doesn't mean you have to abandon your quest to convert your IRA to a Roth. If you recharacterize an IRA you converted last year, you can convert back to a Roth once 30 days have elapsed, says Ed Slott, an IRA expert and certified public accountant in Rockville Centre, N.Y.
Converting your IRA back to a Roth is a smart move, Slott says. Tax rates are likely to rise in the future, he says, so converting now will allow you to take advantage of current tax rates.
Once you convert to a Roth, withdrawals are tax-free, as long as you're at least 59½ and have owned the Roth for five years or more. "If the market comes back and values go way up, all of those gains will be tax-free forever," Slott says.
And converting now — or reconverting if you recharacterized your IRA last year — is a risk-free strategy, Slott adds. If the market continues to slide, you have until Oct. 15, 2010, to recharacterize your Roth.
Income limits lifted
Unfortunately, if your modified adjusted gross income exceeds $100,000, you can't convert a traditional IRA to a Roth.
That cutoff applies to both single taxpayers and married taxpayers who file jointly. Married couples who file separately are ineligible to convert.
But next year, the income restrictions on Roth conversions will disappear. Taxpayers who convert will also be allowed to postpone the tax bill. If you convert in 2010, you'll be allowed to pay half the tax bill in 2011 and the other half in 2012, Slott says.
Picker says he's advising his high-income clients to stash as much as possible in non-deductible IRAs this year so they'll have more money to convert in 2010.
Non-deductible IRAs are the only IRAs available for taxpayers who don't qualify for a Roth or a deductible IRA.
Many financial planners aren't big fans of non-deductible IRAs because withdrawals are taxed at ordinary income rates.
And if you own a non-deductible IRA, you're required to take minimum annual withdrawals once you turn 70½.
But once you convert your IRA to a Roth, those drawbacks disappear. Withdrawals are tax-free (as long as you meet the aforementioned requirements), and Roths aren't subject to the required minimum withdrawal rules.
You have until Wednesday to invest in a non-deductible IRA for 2008, Picker says.
You have until April 15, 2010, to invest in a 2009 IRA, but investing now will give your money more time to grow.
You'll still, of course, have to come up with the money to pay taxes on any gains you earn on your IRA. But allowing investors to postpone the tax bill — and then spread out the payments — will make that aspect of converting a lot less painful, Slott says, adding: "The government is giving everyone an interest-free loan to build a tax-free savings account."