When converting a traditional individual
retirement account (IRA) to a Roth IRA, transferred amounts must
be included in income if taxable when withdrawn (i.e., contributions
and earnings in traditional IRAs and earnings in nondeductible
IRAs), but are exempt from the 10% federal income tax penalty.
In 2009, your adjusted gross income (AGI) cannot exceed $100,000
in the conversion year, excluding any converted amounts. Starting
in 2010, you can have any amount of AGI and still convert to a
Roth IRA.
To use this strategy effectively, you need
to decide when to convert. Recent stock market declines have lowered
the cost of converting, since taxes are paid based on your investments'
value on the conversion date. However, if those values decline
after you convert, you end up paying taxes on more than the current
market value.
If you're in that situation, consider recharacterizing
your conversion. For conversions made in 2009, you can recharacterize
until October 15, 2010, meaning you can convert back to your original
traditional IRA. Just make sure not to take possession of the
funds. The transfer from the Roth IRA to the traditional IRA should
be a trustee-to-trustee transfer. After the recharacterization,
it is as if you did not convert, so you owe no taxes. If you already
filed your 2009 tax return and paid the taxes, you can file an
amended return to get a refund. You can then reconvert at a later
date. The reconversion can be completed at the later of 30 days
after the recharacterization or the beginning of the tax year
following the first conversion.
You can recharacterize just a portion of
the conversion. However, if you have several investments in the
IRA, you can't simply choose the ones with the largest losses.
In that situation, a pro-rata portion of all the investments in
the account will be considered in the recharacterization. You
can bypass this rule by setting up separate Roth IRAs for each
investment. Then, if one declines substantially, you can recharacterize
that one Roth IRA account, leaving the other accounts intact.
There are other situations where you might
want to recharacterize. You might have converted to a Roth IRA,
thinking your income in 2009 would be less than $100,000. If you
later find out your income is over that threshold, you can recharacterize
the conversion to avoid taxes and penalties. You can also recharacterize
annual IRA contributions. Perhaps you contributed to a traditional
IRA, but find your income is over the threshold. You could recharacterize
to a Roth or nondeductible IRA contribution.
