by Bob Rywick
While a decline in the value of a traditional or Roth IRA (e.g., because of a general stock market decline) has no immediate tax effect on pre-retirement-age taxpayers, there are some tax strategies that IRA owners should consider if such a decline occurs.
Converting traditional IRA to Roth IRA
If an owner of a traditional IRA is eligible to convert it to a Roth IRA, a good time to make the conversion would be when the value of the traditional IRA has declined substantially. This is especially so if the owner believes that the decline was due mainly to a general stock market decline such as we’ve had recently, and also believes the market is close to its bottom.
Because the conversion is a taxable transaction to the extent that the converted amount is attributable to pre-tax contributions and earnings, converting after the value has declined will reduce the tax that will have to be paid.
Example (1): Your client is eligible to convert a traditional IRA to a Roth IRA. On March 1, 2000, when he first considered making the conversion, the value of his traditional IRA was $250,000. The entire value of the IRA was attributable to pre-tax contributions and earnings. At that time, you told him that he would have to pay additional federal and state income taxes at an average combined tax rate of 37 percent if he made the conversion at that time. This would result in additional taxes of $85,000. He decided at that time that it would be too costly to make the conversion.
The value of his IRA has now declined to $110,000. As a result of the decline, and also the reduction in federal income taxes effective in 2002, the average combined federal and state tax rate if he converts his traditional IRA to a Roth IRA would be 31 percent. Thus, he will have to pay only $34,100 in additional taxes on the conversion (31 percent of $110,000).
Recharacterizing a Roth IRA as a traditional IRA
A taxpayer who converted from a traditional IRA invested in stocks to a Roth IRA when the market was substantially higher, would have to pay substantial taxes on that conversion even if the market declined soon after the conversion took place. If the decline is steep enough, the taxpayer could end up paying an amount in taxes that equals or exceeds the current value of the IRA.
Fortunately, a taxpayer can treat the conversion as if it had never been made by recharacterizing it. This involves transferring the converted amount (plus earnings or minus losses) from the Roth IRA back to a traditional IRA through a trustee-to-trustee transfer.
A taxpayer is eligible to make the recharacterization as late as Oct. 15 of the year following the year in which the conversion to the Roth IRA was made providing that he filed a timely tax return for the year in which the conversion was made.
Example (2): On Feb. 10, 2001, your client converted a traditional IRA with a then-value of $350,000 to a Roth IRA. As a result of the conversion, he paid $130,000 in additional taxes on timely filed federal and state income tax returns for 2001. The value of the IRA has since declined to $120,000, or less than the total taxes he paid. He has until Oct. 15, 2002, to recharacterize his Roth IRA as a traditional IRA and file amended federal and state income tax returns to get a refund of the $130,000 in taxes that he’s paid.
Reconverting a traditional IRA to a Roth IRA
A taxpayer who converted an amount from a traditional IRA to a Roth IRA may not only transfer the amount back to a traditional IRA in a recharacterization, but may later reconvert that amount from the traditional IRA to a Roth IRA. However, the re-conversion cannot be made before the later of:
- the beginning of the tax year following the tax year in which the amount was first converted to a Roth IRA; or,
- the end of the 30-day period beginning on the day on which the IRA owner transfers the amount from the Roth IRA back to a traditional IRA by way of a recharacterization.
This rule applies regardless of whether the recharacterization occurs during the tax year in which the amount was converted to a Roth IRA or the following tax year.Example (3): Your client converted a traditional IRA to a Roth IRA on Jan. 15, 2001. On Aug. 20, 2002, he recharacterizes the Roth IRA as a traditional IRA. He would be eligible to reconvert the traditional IRA to a Roth IRA on Sept. 19, 2002, the day after the end of the 30-day period that began on Aug. 20, 2002.
Example (4): The same facts as Example (3) apply, except that your client’s conversion to a Roth IRA was made on Jan. 15, 2002. He would not be eligible to reconvert the traditional IRA to a Roth IRA until Jan. 1, 2003.
Observation: Determining when to recharacterize a Roth IRA as a traditional IRA and then reconvert depends, to a large extent, on how the IRA owner expects the IRA’s investments to perform. If the owner expects the market to remain low for a while but doesn’t expect it to get much lower, he should recharacterize the Roth IRA now, and then reconvert as soon as eligible if the market is still low.
Losses on investments held by traditional IRAs
Losses on investments held by traditional IRAs are recognized only if:
- The IRA owner has made nondeductible contributions to the IRA;
- The total amount in all the IRA owner’s traditional IRAs is distributed; and,
- The total amount distributed is less that the total amount of the nondeductible contributions.
If all of the above conditions are met, the loss is recognized to the extent that the total amount of the nondeductible contributions exceeds the total amount distributed.Example (5): Your client has a traditional IRA, which was funded solely with nondeductible contributions totaling $20,000. This means that his basis in the IRA is $20,000. It is his only traditional IRA. He has taken no distributions from the IRA, and its present value is only $15,000. If your client withdraws the entire $15,000 now, he will have a loss of $5,000 ($20,000 less $15,000) which he can claim on Schedule A to his 2002 Form 1040 as a miscellaneous itemized deduction. The amount deductible will be subject to the 2 percent-of-AGI floor for miscellaneous itemized deductions.
Remember, however, that a taxpayer who made substantial nondeductible IRA contributions to traditional IRAs, and then withdraws the entire amount to claim a loss, will lose the chance of deferring gain if the value of the IRA’s investments goes up again.
Caution: Before withdrawing the entire amount in a traditional IRA to claim a loss, find out how much of the loss will actually be deductible after taking the 2 percent-of-AGI floor into account.
Losses on investments held by Roth IRAs
Under IRC ¤ 408A(a), Roth IRAs are treated the same as traditional IRAs unless otherwise indicated. Because IRC ¤ 408A doesn’t prescribe rules governing Roth IRA losses, they are subject to the same rules that apply to losses in traditional IRAs. As a result, losses on investments held within a Roth IRA aren’t recognized when the losses are incurred. However, if the taxpayer liquidates all of his Roth IRAs, a loss is recognized if the total amount distributed is less than his total unrecovered basis, namely, his regular and conversion contributions, all of which are nondeductible contributions.
The loss is an ordinary loss but, as is the case with traditional IRAs, only can be claimed as a miscellaneous itemized deduction subject to the 2 percent-of-AGI floor.
Example (6): In 1999, your client (who is now over 59-1/2) converted his traditional IRA to a Roth IRA when its total value was $220,000. He made nondeductible contributions of $2,000 to the Roth IRA in 2000 and 2001. He has no other Roth IRAs. The value of his/her Roth IRA is now only $150,000. Your client, who is a single taxpayer and itemizes his deductions on his tax return, expects to have about $90,000 of AGI, and about $75,000 of taxable income in 2002. His Federal income tax on $75,000 will be $16,815.
If he liquidates his Roth IRA when its value is $150,000, he will have a loss of $74,000 (basis in IRA of $224,000 ($220,000 received on conversion from traditional IRA plus $4,000 in additional contributions) less $150,000 value). If he has no other miscellaneous itemized deductions, he would be able to claim $72,200 of his loss on the liquidation of the IRA as an itemized deduction - $74,000 less $1,800 (2 percent of AGI of $90,000).
This will leave him with taxable income of $2,800 and a federal income tax for 2002 of $280. Thus, by liquidating his Roth IRA completely, your client will save $16,535 in federal income taxes for 2002 ($16,815 less $280).
Observation: When you liquidate a traditional IRA, you lose the chance of deferring income taxes on gains or income that would be received if you hadn’t liquidated it. When you liquidate a Roth IRA, you’re not just losing the chance to defer recognition of income; you’re losing the chance to take out future income and gains tax-free.
In advising clients whether to liquidate a Roth IRA in order to get immediate tax savings, you should weigh the possible loss of future tax savings if the Roth IRA is not liquidated against tax savings in the year you’re considering liquidating it.
In making the decision whether to liquidate, consider factors such as the client’s age, the client’s (or the client’s investment advisor’s) belief about whether the Roth IRA will recover all or part of its lost value, and the period of time over which such a recovery is expected.
Caution: Under IRC ¤ 408A(d)(3)(F), a 10 percent premature withdrawal penalty tax applies if a taxpayer makes a traditional-IRA-to-Roth-IRA conversion and then withdraws converted amounts (under the sourcing rules) within the five-tax-year period beginning with the tax year in which the conversion took place.
Because the penalty tax applies to a distribution to the extent that the converted amount was taxable when the conversion took place, a taxpayer could wind up paying a penalty tax even though none of the distribution is includible in income.
However, the 10 percent penalty tax doesn’t apply if one of the Code Sec. 72(t) exceptions applies. Thus, for example, it doesn’t apply if the taxpayer has attained age 59-1/2, or has enough qualified higher education expenses or enough first-time home-buying expenses.
