Did you convert an IRA to a Roth IRA in 2001? If so, you may be able to reverse your decision–and save taxes. Upon conversion, all the deferred income tax is due. Say you have a $500,000 IRA and all contributions have been deductible. By converting to a Roth IRA, you’ll recognize $500,000 in taxable income.
Why would you do this? Because, after five years and age 59 1/2, whichever comes later, all Roth IRA withdrawals are tax-free. No minimum required distribution rules apply. But a 2001 Roth IRA conversion won’t be final until October 15, 2002. That’s the last date for filing 2001 tax returns, including extensions. Until then you can recharacterize (rescind) the Roth IRA conversion and change your account back to a regular IRA. Suppose you converted a $500,000 IRA in 2001 but the stock market has dropped since then. Now that account is worth only $400,000. You have until October 15 to recharacterize the conversion and not pay tax on the $500,000 conversion. If you have paid the tax already, you can recharacterize the IRA by October 15 and get a refund.
Once you recharacterize a 2001 Roth IRA conversion in 2002, you can re-convert to a Roth IRA after 30 days. Say you converted your $500,000 IRA to a Roth IRA in 2001 and recharacterize on October 15, 2002. You once again have a regular IRA.
Suppose your IRA falls in value to $350,000 by December 1, 2002. You can convert that IRA to a Roth IRA and pick up only $350,000 in taxable income. This process can be repeated year after year; however, your income must be no greater than $100,000 in any year you convert an IRA to a Roth IRA. You may eventually wind up converting at or near the bottom and paying a relatively low tax on a Roth IRA conversion. After the conversion, if the stock market eventually recovers and your IRA regains its lost ground, all of that growth can be completely tax-free.
Keep in mind that the taxable income from the conversion won’t count towards the $100,000 ceiling. If your income is $60,000 this year, you can convert a $500,000 IRA, or even a larger one.
Moreover, now that the stock market is down, 2002 may be an ideal time to convert your IRA to a Roth IRA. If so, you will have until October 15, 2003, to decide whether or not to recharacterize the conversion, as described above.
