Roth "Option" Set to Expire

Save by undoing 2007 conversions

By Kaye A. Thomas
Posted October 7, 2008

People acting by October 15 may save a bundle.

Most people with market losses have limited ability to share them with the IRS. An overall capital loss in a taxable account offsets only $3,000 of your income from other sources. Losses in retirement accounts aren't deductible either. People who suffer losses in a Roth account after a conversion, though, have an opportunity to undo the conversion and recoup tax paid on the higher value the account had in the past. You have to act on time, though, and for most people who did a Roth conversion in 2007 the deadline is just days away: October 15.

How it works

Suppose you converted a traditional IRA to a Roth a year ago. At that time the account had a value of $100,000, so that's the amount of income you reported on your 2007 income tax return, paying combined federal and state income tax of $30,000 on that amount. After taking a battering in the market, the account is now worth only $60,000. There's nothing you can do about the loss of value in your account, but if you act fast you can do something about the tax you paid on last year's conversion.

To do this, you have to contact the IRA provider where you currently have your account and tell them you want to undo the conversion. They'll move your assets out of the Roth and back into a traditional IRA. As a result of the conversion you'll be treated as if you never converted the IRA in the first place. That means you can recover the $30,000 tax you paid on the conversion. After the required waiting period you can do another conversion. Assuming the account value remains at the current level of $60,000, you'll pay about $18,000 of tax on that amount. The net result is that you reduced the tax cost of your Roth conversion by $12,000.

The ability to undo a conversion puts you in a position similar to someone holding a stock option (specifically, a put option). If your investments perform poorly after the conversion, you exercise the option by undoing the conversion and recovering the tax. If your investments perform well, you keep the conversion and let the option expire.

Caveats

There are a few things you need to know before moving forward. First, the October 15 deadline applies only if you either filed your return by April 15 or filed for an extension by that date. If you somehow let the April 15 deadline slip without filing for an extension, you're no longer eligible to undo your 2007 conversion.

Just because you qualified to do a conversion in 2007 doesn't mean you'll qualify to redo your conversion in 2008. A change in income or filing status could disqualify you from redoing the conversion. Depending on circumstances, the benefit of undoing the 2007 conversion might not be great enough to outweigh the detriment of being frozen out of a Roth conversion for another year or two. (Under current law, the income and filing status restrictions on Roth conversions are repealed as of 2010.)

Even assuming you qualify for a new conversion, the tax savings might not be what you would hope for if your tax bracket is higher in 2008 than it was in 2007.

On the other hand, some people might be in a lower tax bracket in 2008, and gain an additional tax benefit from that change.

Amended return

As a technical matter, if you've already filed your 2007 return, the deadline for undoing a 2007 conversion has passed but you're taking advantage of a rule that grants an automatic extension of that deadline. This isn't a terribly important distinction, but it means you're supposed to alert the IRS that you're using this rule by writing at the top of your amended return (Form 1040-X) "Filed pursuant to section 301.9100-2."

October 15 is the deadline for undoing the conversion and if you haven't filed your tax return you'll have to file by that date as well. If you've already filed, though, you don't have to file the amended return by that date. If your accountant is snowed under with other people who filed on extension you can file the amended return later. Act promptly, though, because the sooner you file, the sooner you'll get a refund of the tax you paid on the 2007 conversion.

Undoing a 2008 conversion

If you did a Roth conversion earlier this year, there's no reason to undo the conversion right away. The deadline is more than a year away. What's more, you won't be able to redo the conversion until 2009. You might as well wait until at least early December, because from that time forward you have to wait only 31 days until you can redo your conversion.