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COMMENTARY | "The best laid plans of mice and men often go awry" must have been said after Robert Burns saw his investment account statement. Staring at at a loss of 10, 15 percent or more is seldom pleasant. If the loss is in a Roth IRA, there might be a remedy, that while not perfect, will help ease the pain.
This is an instance in which your financial adviser can help you navigate the system. If you did elect last year, to convert all or part of your traditional IRA, which is taxable at distribution, into a Roth IRA, in which distributions are tax-free, you incurred a tax bill. The size and severity of the tax bill was based on your own tax return, but I had clients who converted small sums, such as $40 thousand and added $15 thousand to their combined federal and state tax bills.
Fortunately, Congress with their prescient wisdom, placed a provision in the law that allows the taxpayer to declare a do-over with regard to a Roth IRA conversion. The taxpayer has until the last due date of the tax return, generally October 15, to declare that they have made a mistake and want to turn the Roth IRA back into a traditional IRA.
This is a relatively simple process. In my practice, all I need to do is complete the paperwork for the client and submit it to the firm that has the IRA. I instruct the custodian of the client's IRA to re-characterize the IRA. Re-characterize in the legal process of undoing the conversion. This event, completely reverses the taxable event that occurred at the time of conversion. The next step is to file an amended tax return, assuming that one has already been filed. In the case I cited above, where the client converted $40 thousand and paid $15 thousand in taxes, the amended return would trigger a refund of the tax created by the conversion, on both a federal and state level. A tax-payer must wait 30 days after re-characterizing the IRA before they can begin a new conversion process.
The remedy does save you from paying taxes on the inflated amount but does not shield you from the investment loss. If converting all or part of a traditional IRA into a Roth IRA is a strategy that you are going to follow, then you will need to do another conversion.
In the example cited above, a loss of 15% on the $40 thousand which was converted and the re-characterized, resulted in a tax savings of nearly two thousand dollars. The decision to declare a do-over is made on a case-by-case basis, taking into account the amount of market loss, the amount of tax savings, the cost of preparing the amended return and whether a new conversion has been done this year.
- Roth IRA
- traditional IRA