IRA Strategies for Market Declines
This year's bear market has a potential silver lining for IRA owners: If you decide to convert your traditional IRA to a Roth IRA, your market-battered balance will result in a smaller tax bill now and provide tax-free retirement income in the future. To be eligible for a Roth IRA conversion, your adjusted gross income can't exceed $100,000 regardless of whether you are single or married.
If you convert your IRA by December 31, you'll owe taxes on your 2008 return at your regular rate on the entire amount you convert. "A market decline gives eligible taxpayers a chance to convert a traditional IRA invested in beaten-down stocks or mutual funds to a Roth IRA at a much lower tax cost than would have been possible when stock market values were high," says Bob Trinz, senior tax analyst with the tax and accounting business of Thomson Reuters.
But keep an eye on your converted Roth IRA balance. If it continues to decline, you could get stuck paying taxes on the higher amount. However, you can undo the conversion by having the Roth IRA trustee transfer the converted amount and any related earnings back to a traditional IRA no later than the due date of your 2008 return (including any extensions through October 15, 2009).
This maneuver, which the IRS refers to as a "recharacterization," will treat your original Roth IRA conversion as if it never happened and there will be no tax consequences. As long as you wait at least 30 days, you can convert to a Roth IRA again.
IRA funds converted to a Roth must remain in the account for at least five years before they qualify for tax-free and penalty-free withdrawals of the converted amount (but not the earnings). Once you are 59 ½, all Roth IRA withdrawals, including earnings, are tax free.