Stock Conversion Offers Tax-Free Rebound

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When stocks slide, taking capital losses can be a savvy move. You’ll cut your taxes now and in the future. However, tax losses help you only if you take them in taxable accounts.

If you take losses in a tax-deferred account such as an IRA, you won’t get any benefits. That said, there may be a way to cash in on an IRA that has been depleted by sinking stocks.

Convert your traditional IRA to a Roth IRA. In order to convert, your income must be $100,000 or less this year. “If you convert now, you’ll probably owe less tax than you would have owed a year ago,” says Ed Slott, a CPA in Rockville Center, New York, who publishes an IRA Advisor newsletter. When the stock market rebounds–as it always has in the past–you can pull out the gains without owing any income tax.

An example can illustrate the possible upside. Suppose John Smith’s income in 2008 is less than $100,000. At the beginning of 2008, he had $500,000 in his IRA, which was invested entirely in stocks and stock funds.

If John had converted his IRA to a Roth IRA then, he would have owed around $175,000 in tax. That assumes a tax rate of 35%, payable to his state and to the IRS.

Let’s say that John did not covert to a Roth IRA then. By now, after stocks tumbled during 2008, John’s IRA is worth only $300,000. If he converts his IRA to a Roth IRA now, he’ll owe $105,000 in tax, at a 35% rate. So a conversion now would be $70,000 less expensive, vs. a Roth IRA conversion early in the year.

Enjoy tax-free income. Saving $70,000 in tax sounds great. This savings though, is available only if John pays $105,000 in income tax. Why would John pay all this tax now when he simply could let his traditional IRA alone, deferring tax until he takes money out? Because paying tax now can be a better deal than paying it later.

Say John Doe leaves the money in his traditional IRA, stocks recover after a few years, and this person’s IRA grows back from $300,000 to $500,000. That $200,000 gain will be inside his traditional IRA. Every penny he withdraws will be subject to federal and state income tax.

On the other hand, those gains can be tax-free after a Roth IRA conversion. “All withdrawals from a Roth IRA avoid income tax five years after the account is opened, as long as the owner is at least age 59-1/2,” says Barry Picker of Picker, Weinberg & Auerbach, a CPA firm in Brooklyn, New York.

Suppose, in the above example, someone converts his $300,000 IRA to a Roth IRA on Dec. 15. “The requirement refers to five tax years,” says Picker. “A conversion during 2008 makes this Year One.”

Thus, on January 1, 2013, John’s Roth IRA will be five years old. As long as John is at least 59 1/2, all withdrawals from that day forward will be completely tax-free. His Roth IRA might grow to $500,000, $600,000, or more, as stocks recover, yet John can take out some or all of the money and owe no tax.

Small bites can provide a tasty meal. Of course, John might not have $105,000 lying around to pay tax on a $300,000 Roth IRA conversion. “Instead, he can do a partial conversion,” says Slott.

Suppose John converts one-quarter of his IRA ($75,000) in late 2008. He would owe tax on $75,000; if this smaller withdrawal reduces his effective tax rate from 35% to 33%, John would owe less than $25,000 in tax on this conversion, for 2008.

In January 2009, stocks might still be trading at depressed levels. John could convert another $75,000 of his IRA to a Roth IRA then and defer paying tax until 2010, when he files his 2009 return.

The more assets you can move from your traditional IRA to a Roth IRA at today’s paltry prices, the more tax-free gains you’ll enjoy when the stocks bounce back.

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