Converting IRAs makes sense now
Should you convert your traditional IRA into a Roth? Or, if you already have a Roth, should you think about turning it back into a traditional IRA?
Because of the stock market decline this year, this is a good time to think again about whether your retirement investments are in the right kind of account. If you want to change, best do it while prices are still low.
If all this is mystifying, you probably haven't plunged into the strange world of Roth IRAs.
Roths are the newer form of Individual Retirement Account that feature tax-free withdrawals in retirement, plus some other advantages over the older traditional IRAs.
There are two ways to put money into a Roth -- open one and start feeding money in each year or "convert" a traditional IRA you already have into a Roth.
Confused? Don't feel bad -- I have to bone up every time I write about this stuff.
How they work
In a traditional IRA, investments grow on a tax-deferred basis -- there's no annual tax on profits, even if the investor sells one investment and buys another. But when money is withdrawn, income tax must be paid on investment profits, as well as on any original contributions that were tax-free at the time they were made.
With a Roth, there is no tax on withdrawals, but neither is there a tax exemption for contributions.
Since Roths were created long after traditional IRAs, investors got the right to convert old IRA holdings into Roths. To qualify, your federal tax return must show a "modified adjusted gross income" of $100,000 or less.
But there's a catch: In the year you convert, you must pay all the income tax due on the traditional IRA, just as you would if you took it all out in a single year after retiring.
This runs against the generally accepted strategy of holding off tax bills as long as possible. So most traditional IRA investors have not converted.
But converting can pay off for investors who think they will be in higher tax brackets in retirement. By converting now, they pay tax at today's lower rates to avoid tax at higher rates later. And they don't have to worry about tax bills looming in retirement.
So far so good, but the strategy doesn't always work out as hoped.
Stock market's effect
Investors who converted to Roths early this year triggered 2002 tax bills based on the profits that were built up in their traditional IRAs.
But stock prices have fallen this year. Had the investors waited until now to convert, the realized profits would have been smaller -- hence the tax bill would be smaller, too.
An investor in this situation has a fairly easy way out -- to undo the conversion and put the money back into a traditional IRA.
For most taxpayers, conversions done in 2002 can be "recharacterized" in this way any time up until Oct. 15, 2003. But since stocks have been rising recently and may continue to rise, it might make sense to recharacterize soon to capture the benefit of today's still-low prices.
What if you are sitting on a traditional IRA and would prefer a Roth? Then you might consider converting to a Roth now, since the taxable gain will be lower than it would be if you wait until stock prices are higher.
Back to traditional
Finally, what if you want a Roth but you regret having converted earlier this year?
In that case, you can recharacterize now, going back to a traditional IRA to escape the tax triggered earlier. Then you can once again convert to a Roth while stock prices are still low.
You must wait until the next calendar year to do this "reconversion." And, if the next year begins within 30 days of the Roth-to-traditional recharacterization, the reconversion must wait until the 30 days have passed.
Fortunately, as an IRA investor you have easy access to help. The folks at the fund company, brokerage or bank that holds your IRA can tell you what you are eligible to do and guide you through the process.