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I currently have about $40,000 invested in an IRA and am thinking about converting to a Roth IRA. Is now a good time to make the switch, or should I let my IRA ride out the bear market and then do it?
-- Mark Dechert, Buffalo, New York
As you probably know, when you convert an IRA to a Roth IRA, you've got to pay taxes at ordinary income rates on the money you pull out of your original IRA (although the portion of the rollover, if any, that represents nondeductible contributions to your IRA wouldn't be taxed).
This makes sense, since the federal government wants to get its share of any contributions on which it provided you with a tax deduction and any earnings that weren't taxed while they were in the account. After you move the money into a Roth, your withdrawals won't be taxed at all, so the conversion is the one time Uncle Sam is able to get his hands on your little tax-deferred stash.
In a perfect world
So if you're thinking of a rollover at a time when stock prices have been going down, you would ideally prefer to make the switch after the stock market has hit bottom. The reason is simple: the lower the value of your IRA account at the time of the rollover, the less you have to shell out in taxes.
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If you do your $40,000 switch now, you would owe $10,800 in taxes, assuming you're in the 27 percent federal bracket and all the money in the rollover is taxable. If the stock market were to fall another 20 percent -- which I'm not predicting and certainly not hoping it will -- bringing the value of your IRA to $32,000, then converting to a Roth at that point would result in a tax bill of $8,640.
The key word here, of course, is "ideally." If you knew in advance that stock prices were going to fall, then it would make sense to hold off till they hit bottom. But I don't know of anyone who can make such predictions. Actually, let me re-phrase that. I don't know of anyone who can make such predictions and be consistently accurate.
The question is whether to wait
As a practical matter, therefore, the question you must ask yourself is whether it makes sense to hold off doing the rollover on the off chance that the market will decline further from here. Or should you go ahead and make the switch now?
I'd recommend just going ahead and doing the rollover now. Sure, stock prices might go down a bit from here. For all I know they could go down a lot. But that's speculation. And I don't think it makes sense to base a decision like this on speculation.
Besides, there's another reason to go ahead with the conversion now: You can change your mind later. That's right, in its benevolence, Congress has seen fit to write into the tax code a provision that allows you to undo a Roth conversion for virtually any reason. So if stock prices fall, you can undo the conversion and then re-do it later when your account balance is lower.
This is known in tax circles as a "recharacterization." There is a time limit for how long you have to pull off this feat, although the deadline is quite generous. Basically, you have until the due date of your tax return for the year you do the conversion, including extensions. That means if you do the conversion now, you would have until as long as October 15th of 2004 year to undo it.
As is always the case in tax matters, there are any number of niggling little details that could complicate what should be a relatively straightforward transaction like this. So before you make the switch, I recommend you read up on some of the rules and regulations governing conversions and recharacterizations -- and then keep your eye on your account balance to see whether it pays to undo it while you've still got time.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged."
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