Believe it or not, a gift from the IRS

The earlier in 2008 your clients convert traditional IRA assets to Roth assets, the longer they have to utilize the re-characterization rules allowed by the IRS. In short, you can "un-convert" your Roth IRA back to a traditional IRA if your investments do poorly before your tax filing deadline in 2009. Although nobody has a crystal ball that predicts how investments will perform, the re-characterization rules are the next best thing -- a tax time machine that lets you have a do-over.

Here is how it works. Say an investor is eligible for a Roth conversion and chooses to convert $100,000 from a traditional IRA early in 2008. The markets do well, and the account assets increase to $140,000 by the tax filing deadline in 2009 (which can be as late as October 15 with extensions). Your client pays income taxes on the conversion amount (the original $100,000) and keeps the Roth IRA as it is, happy with the investment results and the fact that they now have a substantial pool of tax-free retirement savings to draw from in the future.

What happens if the same investor converts to a Roth in January and the markets head south? If the same account were to drop in value to $60,000, the investor would still be taxed on the original conversion amount of $100,000. In this case, re-characterizing the Roth back to a traditional IRA would erase the tax liability of the original conversion -- a chance to see how their investments perform before locking in the taxes.

In another scenario, an investor could establish two Roth conversion accounts, each with a different investment strategy. At tax-filing time, the investor could choose to re-characterize one, both, or neither of the Roths back to the original IRA if their investments do poorly. This would avoid the tax hit on the conversion.

The rules on conversions and re-characterizations are relatively straightforward. In order to be eligible to convert to a Roth, the investor's MAGI must be below $100,000 in the year the conversion occurs. Investors who file as Married filing Separate are not eligible for Roth conversions, regardless of MAGI. The conversion is considered to be in the year the money leaves the IRA, not the year that it arrives in the Roth account, so a conversion that begins in December 2007 would be considered a conversion for that year, even if the funds aren't transferred to the Roth until 2008.

Roth conversions are treated like IRA rollovers -- they are not considered distributions (so there is no pre-59 1/2 tax penalty assessed) -- but they are also treated as taxable income to the investor for the year the conversion occurs. However, to keep it simple, the amount converted does not get counted against the client in determining the MAGI eligibility requirement. In other words, the client can convert any amount from an IRA to a Roth in a single year, just as long as their MAGI from all other sources is under $100,000.

It's important to identify a source of funds to pay for the taxes for the conversion outside of the IRA account. If you take a distribution from an IRA to pay the taxes, it will be considered additional taxable income and is subject to the 10 percent pre-59 1/2 penalty.

The best scenario for making a substantial conversion to a Roth would be if the client has little current income, has a large amount of money in their IRA, and who anticipates a long retirement with increasing income in future years.

The best time to establish a Roth conversion strategy is early in the calendar year -- allowing a longer time to take advantage of the unique opportunity provided by the IRS. We don't get many gifts from the IRS -- you should consider taking advantage of this one for your clients.

*For further information or to contact this author, please use the forum below.