Most financial choices don't come with a do-over, especially when taxes and investing are concerned. But investors who now regret converting their IRAs (individual retirement accounts) to Roth IRAs, can reverse this decision by Oct. 17.
Before I dive into the details, let's get everyone up to speed. A traditional IRA is a retirement account you open through a bank or investment company that generally provides a tax break today, but requires you to pay taxes on the money when you take it out in retirement.
A Roth is funded with after-tax dollars with the big plus of taking that money out tax-free upon retirement.
When financial experts look into their crystal balls, the majority see higher tax rates in the future, which makes it more attractive to pay tax on investments now, at what are considered to be relatively low tax rates, than at potentially sky-high rates in the future. So the IRS gives investors the option to convert their traditional IRA assets into Roth IRA assets by paying the taxes today instead of years down the road. (I've heard the government could use the money.)
The year 2010 was a big one for conversions because the rules changed to allow anyone to perform this trick. Before, anyone who made more than $100,000 was out of luck. As a special bonus, savers who converted their IRA to a Roth in 2010 were given two years to pay the taxes owed, easing the burden of finding a chunk of change for Uncle Sam.
But that good deal turned out not to be the best deal, considering this summer's markets slump. Say someone owes taxes on a $50,000 IRA because they converted it to a Roth. Now, because of market declines, their portfolio is worth only $40,000. They're probably thinking "Gee, wish I timed that better."
This is where the do-over comes in. With a so-called "recharacterization," savers can reverse the IRA switcheroo, turning their recently converted Roth IRA back to a traditional IRA.
"Why pay the IRS based on a $50,000 conversion when you're not going to get the benefit of that for a number of years because [the account] is depressed so much in value?" explained Damian Winther, a certified financial planner in Edina.
In addition to investors bummed that they owe tax on a now-deflated portfolio, the strategy appeals to individuals who recently entered a lower tax bracket, perhaps due to a job loss. Why not reverse the conversion and reconvert the money, paying tax at their new lower tax rate?
Of course if you've fallen on hard times, it can be tough to scrape together money to pay the tax. Paying tax out of the IRA balance is a no-no because you'll be taxed on the full amount and if you're younger than age 59.5, you'd be penalized for taking an early withdrawal on the money used to pay for taxes. "It doesn't make any sense," said Bloomington certified financial planner Jon Meyer.
There is a limit to how often you can employ this strategy. You must wait at least 30 days, or the following year -- whichever is later -- before taking assets you just recharacterized and turning them into a Roth again. That means you risk recharacterizing and then having the market skyrocket, making a new conversion more expensive. However, there is no rule saying your spouse couldn't convert his or her IRA right away.
Besides, many investors choose only to convert part of their assets. Falcon Heights-based accountant Todd Koch says he's lived through periods when tax rates went as high as 90 percent and is a big fan of tax diversification. "The best way to respond to changing tax rates is to have a diversity of tax options" for when you take the money out, he said.
Of course, recharacterizing involves paperwork, and deadlines, and can be a hassle not worth taking depending on the dollar amount. It's also possible that your financial institution charges a fee for opening new IRAs, Koch warned. Plus commingling money converted in multiple years can create major headaches when trying to calculate gains and losses. Meyer suggests opening a Roth each time you convert money. They can always be combined down the road.
Given the market's recent correction, now may be a good time to consider a conversion from an IRA to a Roth. Get the taxes out of the way today on a smaller pot of money and watch it grow tax-free until you withdraw the funds tax-free, or decide to pass the money to your heirs. If the market heads further south, or you fall into a lower tax bracket, you have until next October for your mulligan.
Kara McGuire • 612-673-7293 or kmcguire@ startribune.com. Twitter: @Kara_McGuire.