IF your retirement assets took a beating in the recent stock market decline, converting a traditional I.R.A. to a Roth I.R.A. may be one of the best tax strategies this year.
When you do the conversion, you must pay income tax on the amount you are converting. This can be the whole account or a portion of it. But, subject to certain restrictions, no tax is assessed when the money is withdrawn. You also avoid the requirement to take yearly minimum distributions beginning at age 70 1/2, which can leave more for your heirs if you don’t use the money yourself.
How much you benefit from the conversion will depend on how the investments do subsequently, but there is great potential. Consider Albert Horrigan, 66, a semi-retired real estate broker in Sarasota, Fla., who converted a $50,000 I.R.A. to a Roth I.R.A. in 1998.
Through a series of investments since then, including Apple stock and what he called a shack on 40 acres in Lamoille, Nev., the account grew to be worth more than $1 million. Had Mr. Horrigan held the same assets in a traditional I.R.A. account, all that growth would have been subject to income tax when he withdrew the money.
Now Mr. Horrigan is thinking of converting another traditional I.R.A. that declined in value by 20 percent this year. If the investment springs back, that appreciation will be free from income tax. And if tax rates increase later, he will have done the conversion at today’s lower rates.
For many, the income limits that apply until 2010 are the main hurdle. You can convert the I.R.A. only if you are single or married filing jointly and your adjusted gross income does not exceed $100,000, after adding back in foreign income, adjustments for foreign housing and other items.
Those who earned less this year than in the past — perhaps because of a layoff or a business setback — may qualify for the first time to do a conversion, said Ed Slott, a C.P.A. in Rockville Centre, N.Y. Even those who do not seem close to qualifying may be able to drive down their taxable income for 2008 enough to come within the limits. Here are some ways to do that:
Reduce YOUR INCOME Business owners can subtract the cost of equipment they bought this year, like computers, machinery and office furniture. These write-offs, under Section 179 of the tax code, can total up to $250,000, as long as they do not push your company into the red.
MAXIMIZE YOUR CONTRIBUTIONS Whether you do a Roth conversion or not, federal law allows you to contribute to traditional employer-sponsored qualified plans, such as 401(k)’s and 403(b)’s. Unlike money in a Roth I.R.A., contributions to these accounts are tax deferred, meaning that every cent you put in, along with all the growth, will be subject to income tax as you or your heirs take out the money.
The attraction for now, though, is that the amount you contribute reduces your adjusted gross income. Currently you can put as much as $15,500 into your 401(k) annually — $20,500 if you’re 50 or older. Depending on their income, self-employed people may also be able to contribute to other company retirement plans, making total deductible contributions of up to $46,000.
TAKE INVESTMENT LOSSES While taxes should not dictate your decision to sell investments that have done poorly, there is a bright side to unloading some losers. Complex rules allow you to subtract at least some losses in calculating how much income is subject to tax. Have your tax adviser run the numbers.
What if, after you do the conversion, the I.R.A. assets further decline in value, or you have a year-end windfall, and your income ends up being more than $100,000? In that case, you can undo the conversion — a process called recharacterization. For a conversion done in 2008, you can recharacterize anytime until Oct. 15, 2009. If you have already filed your return and paid the tax, you will need to file an amended return and claim a refund.
Once you have recharacterized, you are not permitted to do another conversion with the same assets until the following year or 30 days after the first conversion — whichever is longer. However, if you still have other money in a traditional I.R.A., you can get around the rule by carving out a separate chunk of your I.R.A. and converting that portion to a Roth I.R.A., said Barry C. Picker, an accountant and financial planner with Picker, Weinberg & Auerbach in Brooklyn.
Each time you do a conversion, create a new Roth I.R.A. rather than mixing funds in an existing Roth account, Mr. Picker advises. That makes it much easier to monitor asset performance, and later recharacterize if necessary.