Bear Market's Silver Lining for IRAs

Those brave enough to open their IRA statements have been numbed by the sight of monthly losses. While no magic wand is at hand to turn back the clock, taxpayers can make certain moves to minimize tax on their accounts and blunt the painful losses to a degree, by considering Roth IRA conversions, in light of years to retirement and risk (see Exhibit 1).

This item does not consider all possibilities. In addition, for all scenarios, it assumes (1) an IRA accountholder has invested mostly in equities and has suffered substantial losses, (2) the market has a good prospect for recovery and (3) the accountholder has sufficient years before retirement to offset taxes paid with future untaxed earnings in a Roth IRA account. (Relevant factors not explored include the effect of lower marginal tax brackets on (and during) retirement.)

Conversion to a Roth IRA

Sec. 408A(d)(3) allows an account-holder to roll over a traditional IRA to a Roth IRA account, provided that he or she includes the rollover amount in gross income and pays the income tax thereon. Given the stock market's plunge, such a move would mean lower taxes than if the taxpayer had rolled over the account when the stock market was higher. The Sec. 72(t) penalties on premature distributions do not apply to such a Roth IRA conversion. However, (among other things), Sec. 408A prohibits a conversion of a traditional IRA to a Roth IRA if, for the tax year of the conversion, the taxpayer's adjusted gross income (excluding from gross income the potential conversion amount) exceeds $100,000.

Conversion from a Roth to a Traditional IRA

Relatively recent conversions of a traditional IRA to a Roth IRA are likely to have been made at a high tax cost. If an account's value has fallen considerably since the conversion, tax will have already been paid on the original amount. The effect of such an unfortunate situation can be compensated for by a recharacterization under Regs. Sec. 1.408A-5. Using a trustee-to-trustee transfer, the conversion could be recharacterized, if made before the due date (including extensions) for filing a Federal income tax return for the tax year in which the individual made a contribution to the first IRA (here, the Roth IRA).

Post-Filing Relief

Relief is also available for a limited time after a taxpayer has filed a return. Regs. Sec. 301.9100-2(b) allows an automatic six-month extension from a return's original due date, if the due date of a regulatory or statutory election is the same as the return's (including extensions). However, corrective action must be taken within a six-month period.

If a Roth IRA is recharacterized as a traditional IRA to minimize tax cost, a taxpayer must transfer the Roth account back to the traditional IRA and file an amended return. The notation "FILED PURSUANT TO 301.9100-2" must appear across the top of the amended return. Thus, a taxpayer who timely files a return by April 15 of the year following the return's tax year has until October 15 (six months after the original due date) to take corrective action.

Multiple Reconversions

Regs. Sec. 1.408A-5, Q&A-9, allows multiple reconversions, if made within specific time periods. An opportunity to realize tax benefits arises if the stock market declines and a previous conversion had been postponed. Caution: a Sec. 408A(d)(3)(F) 10% premature withdrawal penalty applies to withdrawals made within the five-year waiting period.

Example: In 2002, E established a Roth IRA with $100,000 converted from a traditional IRA. E included the converted amount in gross income, resulting in an additional $33,000 of Federal income tax, using a 33% blended Federal rate. By August 31, 2003, E sustained a 40% loss on the account and recharacterized the $60,000 back to a traditional IRA. Later, an updated analysis showed that a Roth IRA offers comparative advantages; thus, E reconverts back to a Roth IRA in accordance with the statutory waiting period (see below), when the account value is still $60,000 and pays a tax of $19,800 ($60,000 x 0.33) on reentry into a Roth account. E saves $13,200 ($33,000 – $19,800) in Federal taxes and perhaps some state taxes as well.

According to Regs. Sec. 1.408A-5, Q&A-9, an IRA owner who converts an amount from a traditional IRA to a Roth IRA during any tax year and then transfers that amount back to a traditional IRA via a recharacterization cannot reconvert that amount to a Roth IRA before the later of the (1) tax year following the tax year in which he or she converted the amount to a Roth IRA or (2) end of the 30-day period beginning on the day on which the IRA owner recharacterizes the contribution from the Roth IRA back to the traditional IRA.

For example, if a taxpayer converts a to Roth IRA in 2002 and recharacterizes that contribution back to a traditional IRA on Aug. 31, 2003 (i.e., the above example), he or she could not reconvert to a Roth IRA before 2003.

Miscellaneous

According to Notice 89-25, Q&A-7, a taxpayer could deduct IRA losses if he or she has basis (in nondeductible IRA contributions made to traditional and Roth accounts). To recognize the loss, the taxpayer must have an unrecovered basis after liquidating all traditional IRA accounts.

Traditional IRA losses are claimed on Schedule A, Form 1040, as a miscellaneous itemized deduction subject to the 2%-of-adjusted-gross-income floor.

Finally, according to Prop. Regs. Sec. 1.408-8, Q&A-9, if a taxpayer with multiple IRA accounts, who has been taking required minimum distribution (RMDs), seeks to avoid selling depreciated securities to meet the RMD, he or she could aggregate the distributions and arrange a single payment from one of the accounts (i.e., a money market fund or other securities free of paper losses).

Conclusion

Tax practitioners can perform a valuable service for their eligible clients by explaining advantageous IRA strategies when market conditions are accommodating. Much of practitioners' thinking has been conditioned on an ever-rising stock market, making conversions to Roth IRAs and expected future appreciation, resulting in huge retirement assets that could be withdrawn tax free, attractive to many not ready to retire. The bear market has changed the rules. However, practitioners can apply attractive tax-saving moves.

From Joseph V. Bencivenga, CPA, PKF, New York, NY