How To 'Undo' A Roth IRA

A change in tax law that allows people to undo popular Roth IRA rollovers has important tax implications for people socked by recent stock market drops.

Because the amount of tax paid on your Roth IRA conversion is based on the value of your regular IRA at the time you converted it, people whose funds have been hit by falling stock prices may face taxes on fund values that are only a dim memory.

Managing Your Money

It is possible, and perfectly legal, to undo the Roth IRA and then reconvert to the Roth at the lower $50,000 portfolio value so you end up with the investment you want (the Roth IRA) but lower the tax implications, according to John Ziegelbauer, a senior tax manager at Grant Thornton in Washington, D.C.

The transfer is known as a trustee to trustee transfer and even though there may be administrative costs, Ziegelbauer says it is worth it to some investors.

The upside benefit of early conversion to a Roth IRA also means that those lucky people whose Roth IRA skyrockets in value after conversion still only report taxable income based on the rollover value. For example, if that regular IRA value of $80,000 in March when it was converted is now $150,000, the increase in value doesn't affect the tax paid based on the $80,000 conversion to a Roth IRA. If you're one of those lucky folks, you don't need to undo anything.

The technical tax law correction has other benefits as well. Originally, the Roth IRA went into effect January 1, 1998. Although the Roth provides no immediate tax deduction for contributions is that all the earnings are tax free when you withdraw them, if you meet the requirements.

Many people wanted to switch regular tax deductible IRAs to a Roth. But to be eligible, one requirement was that a taxpayer's adjusted gross income could not exceed $100,000. That left many people at or near the $100,000 limit fearful that if they exceeded the limit they might be penalized. So, many investors planned to wait until the end of the year when they would know their total income.

To eliminate this uncertainty, Congress clarified the law to allow people who might unexpectedly exceed the $100,000 limit to undo the Roth IRA conversion without penalty, if it was switched before they filed that year's tax return.

But the way the law was drafted, anybody had the ability to undo the Roth IRconversion, Ziegelbauer said. He noted a taxpayer with a Roth IRA conversion of $100,000 in July 1998, that subsequently falls in value to $90,000 in December 1998 would save $3,600 in taxes by "undoing" the July Roth IRA conversion and reconverting to a new Roth IRA as of December at the $90,000 value.

There are several uses for the reversal of a Roth IRA you previously rolled over from a regular IRA:

• You learn your adjusted gross income is above the $100,000 limit. Undo the conversion.
  
• Market losses after conversion to a Roth IRA mean you could report less tax if you were converting the IRA based on the lower market value. Undo the conversion and then do a new Roth IRA conversion based on the lower value.
  
• You find out you don't have enough money to pay the tax on the conversion and it was just a mistake. You may undo it.
  
• You discovered the added income might prevent your child from qualifying for financial aid in college. You may undo the conversion.

This is a highly technical part of the tax law with very specific requirements to qualify. And we're talking about your retirement.

We've only scratched the surface here. Fairmark Press has an extensive discussion of Roth IRA conversions on their Web site if you want more details.

Undoing the Roth IRA must be a trustee to trustee transfer. If you receive any of the funds it may significantly affect your tax liability and your ability to make the conversion.

Ziegelbauer pointed out that there are other ways to deal with contributions you didn't want to make to a Roth IRA, other than undoing to Roth. He said you should make sure you understand them before you play with your retirement savings.

Timing is a critical factor. Ziegelbauer points out to take advantage of market dips in conversions to Roth IRAs requires you to act promptly when the value of the portfolio is low. But he also points out the timing may affect your ability to spread the tax payments over four years.

If you think you might save tax dollars by undoing a Roth IRA, talk to your tax planner and read up on the issue to make sure you understand all the implications for your particular situation.

By Pam MacLean