Readjusting Your Stocks to Save on Taxes

Nov. 25, 2008 — -- As 2008 nears an end, it's time for ravaged investors to make the best of a bad situation.

There are a number of tax-planning moves investors can make to help mitigate some of the losses they've suffered this year. They include selling losing investments to offset gains and deducting losses and converting a traditional IRA into a Roth IRA at a depressed value to realize future tax savings.

One other move that some investors should be considering in the coming weeks is the opposite of a Roth IRA conversion; it's a Roth IRA recharacterization. That's a mouthful for sure, but a recharacterization essentially is a do-over in the tax world. It's a chance to go back and undo what you did.

Those who will want to consider a do-over are retirement savers who earlier this year converted their traditional IRA to a Roth IRA and then watched stock prices enter a free fall.

If the $20,000 you converted into a Roth IRA at the beginning of this year now stands at $12,000, you should consider a recharacterization. Why pay taxes on that $8,000 in lost value when you can go back and redo the conversion at a lower cost?

To understand how a recharacterization works, first you need to know a little bit about why you'd want to have a Roth IRA in the first place. The primary benefit is that money held in a Roth can be withdrawn in retirement with no income taxes due. A secondary benefit is that there is no requirement for mandatory withdrawals after age 70½ as with traditional IRAs and other retirement savings accounts.

The downside of a Roth is there are no tax savings on the front end when contributions are made as with other retirement plans. However, the tax-free withdrawals in retirement can more than make up for that disadvantage if you believe your tax rate is likely to be higher in retirement than it is now.

You can establish a Roth IRA by making annual contributions provided you meet the income guidelines, but you're limited to contributing $5,000 a year (or $6,000 a year if you're 50 or over).

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.

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.

In the process of recharacterizing a Roth IRA, you also will need to notify the custodian of your account. I'd suggest a call to the custodian as a way to start making the best of a bad market this year.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com.