IRA Recharacterization Rules

As the stock market continues its roller coaster of 2009, many are seeking for positive news. While I’m sure that there are many good buys out there, one thing that is certain are that we can look to benefit from tax savings. How, you ask? Well, in down times, one thing that investors can look forward to is to take advantage of things such as tax loss harvesting in taxable investment accounts, which involves selling depreciated holdings to take advantage of losses that can offset other income. Not only in taxable accounts, but we may also be able to take advantage of retirement accounts as well. This is what’s called IRA Recharacterization. Some of the issues can be complex; but with a little bit of information, we can try to make sense and explain the rules.

The Roth IRA Conversion

As you may or may not know, Roth and traditional IRAs are retirement vehicles that allow you to shelter income from taxes. In a Roth IRA, withdrawals can be tax-free and as an investor, you are not required to take distributions at the age of 70 ½ as you would with a traditional IRA. The trade-off, of course, is that with the Roth IRA there is no tax deduction like you would get with a traditional IRA or a 401(k).

In a market as such, some investors may have done what’s called a conversion where they have converted their traditional IRA to a Roth IRA. This could be advantageous for some that are looking to take advantage of the tax-free withdrawals in the Roth IRA. The one drawback by converting is that when you do convert from a Roth IRA to a traditional IRA, the entire amount is treated as ordinary income, which means we will have to claim that amount on your income taxes for the year and pay the appropriate income tax. For those that had converted for 2007, the value that was converted then, if invested in the stock market, most likely is worth less now. As an example, if you had $20,000 in your traditional IRA that you converted last year that value may be worth only $15,000 today.

IRA Recharacterization Rules

A couple rules to keep in mind if you are trying to recharacterize a conversion from a Roth back to a traditional is that you are not allowed to reconvert back to a Roth within the same tax year or within 30 days of the IRA recharacterization. In other words, an IRA that has switched to a Roth earlier this year and then switched back can’t be reconverted to a Roth this year. The reconversion has to be delayed until at least January 1 or if later, 30 days after the IRA was switched back to the traditional.

Example of IRA Recharacterization

For example, somebody in a 30% federal income tax bracket who converted a $20,000 IRA last year in 2009 would owe approximately $6,000 in taxes. If the account was fully invested in the stock market, it may be possible that account is now worth down to 15,000 due to market depreciation. Assuming that the value of the investments in the account didn’t change between the time of the back and forth switch, the tax bill would be reduced to $2,100.

These rules governing IRA conversions are complex. It’s crucial to get them straight. You have until October 15th of the calendar year following conversion to switch back to a traditional IRA. By the time you read this post, chances are that time has already passed for 2008, but if you had done a conversion in the beginning of 2009, it may be something to consider for next year.

Don’t Forget The Capital Loss

Other tax saving opportunities that you can take advantage of in a down year in the market also has to do with offsetting investment gains up to the $3,000 capital loss that you’re allowed . One thing you should know is that if you do have an investment that is down, you are able to sell that off, take advantage of the $3,000 capital loss, but due to the wash sell rule, it prohibits you from repurchasing that same investment within a 30-day time period.