CHICAGO (AP) — The stock market’s summer nosedive was extra painful for those who recently converted their Individual Retirement Accounts to Roths.
Not only did their retirement savings shrink when the Standard & Poor’s 500 index fell 16 percent in three weeks. Suddenly, they faced the prospect of paying thousands of dollars more in taxes than otherwise necessary. That’s because the tax cost of changing an account is fixed at the time it’s formally converted by your brokerage or investment firm.
Roth IRAs provide tax-free growth and have surged in popularity because of both their long-term tax and savings advantages and the relaxing of rules in 2010 that barred those with incomes above $100,000 from converting.
But the market drop left many of those who joined the rush to convert to them regretting their decisions because they still must pay taxes on the higher amounts that sat in their accounts last year. Investors flooded financial advisers with calls and emails about getting out of their Roths in early August, before stocks turned higher.
They still have more than a month to undo them. Unlike with a bad stock purchase, a do-over is possible with Roth conversions until deep into the following tax year.
This year, those who want to ditch the Roths they established in 2010 because of adverse tax consequences or any other reason have until Oct. 17 to undo or “recharacterize” them. Those who do so will avoid paying the tax bill for the conversion or, if they already paid, get their money refunded.
“It’s a way to save a lot of money during a down market for those who have seen their account values depreciate significantly,” says Ryan Himmel, a New York CPA who heads BIDaWIZ Inc., an online marketplace for tax and financial advice. “You’re leaving money on the table if you’re not considering this.”
Reversing a Roth also can push large tax obligations into the future, when you may have more cash to absorb them.
That was the case for the Segals of suburban Cleveland. They converted a chunk of their retirement savings to a Roth in March on the advice of their financial planner. Then they reversed course weeks later when they realized just how hefty the tax bill would be and that it would push them into a higher tax bracket.
Barb, a retired medical educator, and Allen, a physician, both 60, said they needed the cash instead for current expenses such as paying down the mortgage.
“We know there are benefits to paying taxes up front rather than later,” Barb Segal says. “But at a time when we are really trying to save and invest as much as possible for our retirement, the immediate tax consequences were too great for us.”
With this year’s deadline just weeks away, here are some basics about Roths and how to undo them:
Q: Why are Roths considered beneficial over the long run?
A: After you pay taxes on the conversion from a traditional IRA, your retirement dollars in a Roth grow and can be taken out tax-free.
Anyone who expects to be in a higher tax bracket at retirement also would benefit by paying the taxes now. And with tax rates widely expected to rise in the future, many retirees may end up in higher brackets than they are currently.
Roths offer greater flexibility in retirement, too. Unlike with traditional IRAs, you are not required to withdraw a required minimum amount every year once you turn 70½. You can let the money keep accumulating tax-free.
Q: What exactly is a Roth recharacterization?
A: It’s the process of undoing all or part of the conversion from a traditional IRA to a Roth IRA.
Q: What’s an example of when you would want to do it?
A: Let’s say you converted a $100,000 IRA to a Roth last year and the value has dropped to $80,000. You will still be paying taxes on the $100,000. You don’t get your money back for any money-losing investments, but you effectively save thousands of dollars in taxes.
Q: How do you know if it’s the right move?
A: If your holdings have already lost substantial value, the decision to recharacterize is a no-brainer, says Ed Slott, a Rockville Centre, N.Y., accountant who specializes in retirement issues. “Why pay tax on value that no longer exists?” he says.
Otherwise, focus on the net savings you’d achieve. The more the Roth’s value declines, the greater the tax benefit.
Factor in the cost of getting professional help, such as paying an accountant to amend your tax return as needed, says Richard Jackson, principal at advisory firm Schlindwein Associates in Dallas. “You would like to not have to recharacterize,” he says.
Q: How often do people undo their conversions?
A: Fidelity Investments, the biggest provider of IRAs, says it typically reverses less than 15 percent of its Roth conversions. But there’s still the potential for many people to do so by the Oct. 17 deadline. Fidelity alone completed about 220,000 Roth conversions last year, more than a fourfold increase over 2009.
Q: What are the down sides?
A: Anyone who converted an IRA to a Roth in 2010 was given the one-time perk of being able to put off paying taxes for a year and pay half each in 2011 and 2012. Losing that tax-deferral deal is probably the biggest negative to recharacterizing, says Tim Steffen, director of financial planning for Milwaukee-based advisory firm Robert W. Baird & Co. By spreading out the tax obligation over time, it made absorbing a big expense more manageable.
Q: So how do you go about making the change?
A: Contact your Roth IRA custodian and ask to recharacterize your account back to a traditional IRA. If you have already paid the conversion taxes, file an amended return to get your money back.
Q: Can you convert back to a Roth later if you recharacterize?
A: Yes. You can reconvert after 30 days.
Personal Finance Writer Dave Carpenter can be reached at http://twitter.com/scribblerdave