The deadline for your extended personal income tax return is now less than two weeks away. That means some other important deadlines are coming up as well. One of those is the deadline to change your mind on a rollover from a Traditional IRA to a Roth IRA, or roth conversion. This has been a pretty popular trick allowing higher income people to take advantage of the tax free growth of a Roth IRA. The only problem is it doesn’t work if your IRA isn’t growing. If you rolled a Traditional IRA to a Roth IRA and the Roth IRA lost value, you are effectively paying taxes on the loss.
Fortunately, the IRS offers a mulligan.
Let’s say for example that back in 2010 for that brief window of time when the economy started looking up, you decided to take your $100,000 Traditional IRA and roll it over to a Roth IRA so that you could then let that money grow tax free. When the money goes into the Roth, it is not tax free, so now you owe taxes on that $100,000. Or at least you owe taxes on the part of that $100,000 that you had deducted in the past.
You pay taxes on the conversion from the Traditional IRA to the Roth IRA. Now it is October 5, 2011. That $100,000 was invested in the up and coming solar industry, the long awaited recovery of government bailed out Citigroup, and Nokia’s next smart phone that would compete with Apple’s iPhone. In other words, your IRA is worth a whole lot less than when you made that original conversion. You paid taxes on $100,000 and only have $50,000 to show for it to grow tax free. You have until October 17th to re-characterize your conversion and make it like it never happened. And it gets even better.
If you made the initial conversion in 2010, you can do it again in 2011. In other words, you can re-characterize your conversion saving taxes on that $100,000 and then do the conversion over again now paying taxes only on the $50,000 and letting that grow tax free. That’s almost a no-brainer. Bear in mind though, there is a 30 day waiting period. So if you think you are going to recuperate your losses in the next 30 days you may want to skip the re-characterization. Of course, if you think you are going to recoup all your losses from the past year in the next 30 days, you may also need to fire whoever is giving you investment advice.
If you have already filed your 2010 tax return, you will need to amend it to recover the taxes paid on the initial roth conversion. If you’ve been a client of ours and fit the right criteria, we may have been having you make non-deductible contributions to a Traditional IRA to roll over to a Roth in order to get around adjusted gross income limits for Roth contributions. If that’s the case, re-characterizing wouldn’t make a difference because the initial conversion would have been partially or completely tax-free. For additional tax strategies for retirement, please feel free to peruse our previous blog entries, and please don’t hesitate to contact us.