Friday, December 12, 2008


Yesterday afternoon I got an email from a long-time client, who is retired, which stated the following –

I just finished a article in the paper about this being a great time to consider converting traditional IRA's to ROTH's because of the tremendous decline in their value and the subsequent reduction in federal tax due upon converting. Converting before the eventual upturn in fund values can result in a huge tax saving over time.”

My client wanted to know if I thought this was something he should consider. He added, “By the way, we probably do not have enough cash in the bank to cover the tax.”

My response included the following -

“Here are some things to consider before making a decision on conversion.

(1) The benefit of a ROTH IRA = the money invested grows tax free. “Qualified” distributions are totally tax free (federal and state). There is no requirement for a minimum annual distribution (RMD) at age 70½. ROTH monies pass to beneficiaries income tax free on inheritance.

(2) In order for a distribution from a ROTH IRA to be considered a “qualified” distribution it must be made after a 5-year period that begins on the first day of the tax year in which you first contribute money to or convert an existing traditional IRA into a ROTH IRA and ends on the last day of the fifth (5th) consecutive tax year. This is a once-in-a-lifetime qualification. Once the 5-year holding period has been satisfied for the first ROTH IRA contribution or conversion, all subsequent ROTH contributions or conversions are treated as having met this condition.

(3) Monies can be converted from a traditional IRA to a ROTH IRA if the taxpayer’s modified AGI for the year in which the conversion is made is $100,000 or less. Modified AGI in your situation is the AGI without regard to the amount of the conversion. The $100,000 MAGI limit will no longer apply beginning in tax year 2010.

(4) Tax is paid on the conversion of a traditional IRA to a ROTH IRA based on the fair market value of the traditional IRA immediately prior to the conversion.

(5) You have until the due date of the tax return for the year of original conversion, including extensions (i.e. as late as October 15 of the year after the year of conversion), to “recharacterize” the ROTH conversion back to a traditional IRA. This would be done if the MAGI for the year exceeds $100,000, or if the value of the IRA investment drops substantially after the conversion. For example – the IRA is worth $100,000 at conversion on June 1, 2008 (taxable income to report is $100,000), but by April 1, 2009 of the year after the conversion the account is worth only $80,000.

(6) One reason to convert a traditional IRA to a ROTH IRA now is that the recent economic mucking fess has reduced the value of the IRA from $100,000 to $65,000. You do not anticipate needing the IRA monies for several years, at which point the current value of $65,000 will have grown back to $100,000 or more.

(7) Another reason why 2008 may be a good year for a taxpayer who has not yet retired to convert to a ROTH is that because of job loss or other factors the AGI for the year may fall below $100,000. Obviously this does not apply to you.

(8) By contributing part of your existing traditional IRA investments to a ROTH you reduce future required minimum distributions from the remaining traditional IRA accounts, as only traditional IRA balances are used in calculating the RMD.

In your case as it is already so close to the end of the tax year, and I doubt there will be substantial upward appreciation to your investments in the next 30 days, you can wait until January of 2009 to make any conversion and push the actual payment of the tax until 2010 – or at least until the due dates of quarterly estimated tax payments. Because 2009 is a new year you will have more opportunity to control your AGI and/or taxable income and tax withholdings.

If you have more than one actual IRA account, as you do, you can choose which account, or how much of an account, to convert to take the most advantage of investments that have gone down in value.”
What I forgot to mention in my email response is that the value of the ROTH IRA assumes that Congress, in its infinite wisdom, will not change the rules for the ROTH in the future. However, that said, I do believe that if any changes are made they would not be retroactive, and would only affect ROTH IRA rules from the date of enactment of any future legislation forward.
Any questions?



Nancy said...

I googled "Converting IRA" and found your site! I have a ? OK here's the deal..I've had an IRA for 20+ years - managed by an investment company - total amount was in the company's own Mutual Fund but all of it was in a Schwab acct - it has tanked (down over 50% and was continuing to plummet) so today I called Schwab and "sold" all of the shares and it is now all cash in the same Schwab account - I just wanted to get it somewhere safe until I decide what to do with it- then I read in your article that I can only roll it over once a year - does what I did count as "rolling it over"? I also read what you wrote about converting it to a Roth IRA - I am 53 - maybe that's what I should do. But now I'm scared that I can't make any more moves with it. I don't trust my investment advisor and my CPA didn't have an answer for me. HELP?

Robert D Flach said...


Here is what I see – You have had a “self-directed brokerage IRA account” with Chuck for 20+ years. It was originally invested in a mutual fund. Because of excessive losses in the fund you had the “trustee” (which is Chuck) sell the mutual fund investment and put the cash in a money market account – or a “cash-sweep” account - while you decide what new investments you would like the trustee to purchase.

I do not see the sale of the mutual fund shares as a “roll-over”. As you indicate the cash is still in the same account with Chuck. Without commenting on the investment sense of what you did, you did nothing wrong legally.

A roll-over would be if you had moved the account from Chuck to Fidelity, or to Chase Bank – physically moved the old account to a brand new account. Or if you had Chuck sell the shares for cash, take the cash out as a withdrawal, and put the cash back into an IRA account within 60 days.

You did not change the “location” of your IRA; you just changed the investment mix within the account.

Again, as I see it, you can choose to have Chuck reinvest the cash in something else within the same account, or you can move the account altogether to another investment advisor (that would be a rollover), or you can convert the traditional IRA account to a ROTH IRA, assuming you qualify.

Does anyone disagree with me?