LOISELLE, GOODWIN & HINDS
CERTIFIED PUBLIC ACCOUNTANTS

NOTE: IRS has issued final regulations clarifying Roth IRA rules. Click here and Here

Shifting In and Out of Roth IRAs

Many of our clients have asked us to help them determine whether they could benefit from converting their regular IRAs to Roth IRAs. (This can only be done by those whose AGI isn't more than $100,000 for the year of conversion.) The two main benefits of a Roth IRA are that:

1. future "qualified distributions" are completely tax-free, and
2. distributions don't have to begin after age 70-1/2, so that tax-free earnings can continue to build for the benefit of account beneficiaries.

The down-side of the equation is that tax is triggered on the conversion from a regular IRA to a Roth IRA. If the conversion is made in 1998, the income from the conversion can be spread over four years, thus lessening the tax impact.

Those who converted to Roth IRAs earlier in 1998 may have done so when the value of their IRAs was inflated by stock market gains that later evaporated when the markets turned sharply downward this summer. However, their tax liability from the conversion was set by the account value at the time of the conversion - not at its diminished value after the market correction. To rectify this situation, some undid their Roth IRAs by "recharacterizing" them as regular IRAs and then reconverting the new IRA to a Roth IRA, setting their tax liability based on the then lower account value. This can be done by making a direct transfer from the Roth to a regular IRA at any time until the tax return due date, including extensions, for the year of the Roth IRA conversion, and then reconverting that regular IRA to a Roth IRA. For example, if a $200,000 IRA account that was converted to a Roth IRA in July dropped in value to $150,000 by late August, switching back to a regular IRA and then reconverting to a Roth IRA would cut the taxable income from the conversion by $50,000.

Some people did this every time their account value dropped, hoping to fix their tax liability at the bare minimum. Until October 31, 1998, that strategy worked. However, the IRS, which hadn't specifically okayed or barred these reconversions, has come out with new rules that permit a person to make only one Roth IRA reconversion that will work to lower taxes from November 1, 1998, through the end of the year, and one additional reconversion during 1999. If "excess reconversions" are made, they won't change the tax result: Tax liability from the Roth IRA reconversion will be set by the account value on the date of the last reconversion that didn't exceed the limitation.

The rules regarding Roth reconversions are quite complicated, and since there may be quite a bit at stake, you should be aware of the following:

• If you haven't yet converted to a Roth IRA and you convert during 1998, you may make one reconversion during 1998, and one reconversion during 1999, should you want to. (You can make additional reconversions, but they won't change the amount of tax you owe.)
  
  
• If you converted to a Roth IRA before November 1, 1998, you may reconvert once during the final two months of 1998, regardless of whether you reconverted and, if so, how many times you reconverted during earlier months. You may also reconvert once during 1999. (Again, additional reconversions are possible, but won't reduce your tax.)
  
  
• If you switch back to a regular IRA during 1998 and don't reconvert to a Roth IRA until 1999, you will not be able to spread out the income from the conversion over four years - the Roth IRA conversion that counts for tax purposes will occur in 1999, and all the income will be taxed in 1999. So, you have to be sure that the income reduction resulting from the reconversion is great enough to offset loss of the four-year income spread. (Note that if you take a distribution from a regular IRA during 1998 and roll it over into a Roth IRA within 60 days, the Roth IRA conversion is treated as made for 1998, and the four-year income spread is allowed, even if the rollover to the Roth IRA isn't completed until 1999. However, the value for tax purposes is determined as of the date of the distribution from the regular IRA.)
  
  
• If you converted to a Roth IRA in 1998 and switch back to a regular IRA in 1999, you must do so by your tax return due date for 1998, including extensions, in order to undo the conversion and its tax impact. So, to keep your reconversion options open (in case there's a market drop in 1999 that may warrant another reconversion), you will probably want to request an automatic filing extension, until August 15, 1999, for your 1998 income tax return.
  
  
• Before undoing a valid 1998 Roth IRA conversion, be sure that your adjusted gross income for 1999 won't exceed $100,000 (not including any income that would result from a 1999 Roth IRA conversion). If it does, you will have undone your 1998 conversion, and won't be able to convert in 1999.
  
  
• If you don't make a Roth IRA conversion for 1998 (say, because your 1998 AGI is more than $100,000), but you convert in 1999, you will be permitted one reconversion in '99.
  
  
• In figuring how many reconversions you are allowed to make, note that if you undo a Roth IRA conversion because it turns out that your AGI is above the $100,000 limit, the original conversion doesn't count at all. So, for example, if you undid a 1998 conversion for this reason, you can convert again in 1999 and reconvert once in 1999.
  
  
• Finally, if for any reason you want to undo a conversion to a Roth IRA and its resulting tax consequences, you are free to switch back to a regular IRA by your tax return due date, plus extensions, for the conversion year. That's true, even if you made more reconversions than the IRS allows, and just want to return to where you started.

If you are considering whether to convert to a Roth IRA, or whether you should switch back to a regular IRA or reconvert to a Roth IRA, contact us and we will be pleased to discuss the factors involved with you.

(11/05/98)

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Last modified: August 19, 1999