If I convert a traditional IRA to a Roth IRA, can I offset gains in the account against outside losses?
Converting to a Roth is almost always a smart thing to do. Since a Roth grows tax-free (whereas a traditional IRA grows tax-deferred), you'll most likely have a larger nest egg come retirement. And now's a particularly good time to convert, since most folks have seen their balances shrink (even if they technically do still have gains) — meaning they'll end up paying less in taxes on the conversion than they would if the account balance was significantly higher. What you can't do, however, is use outside losses to offset gains in the account. But by the time you're done reading this, we bet you'll still think converting is the way to go.
As you know, when you convert a traditional IRA to a Roth you need to pay Uncle Sam any taxes that had previously been sheltered. (Your adjusted gross income must also be $100,000 or below.) If you have a tax-deductible IRA, you'll owe taxes on your contributions and earnings; with a nondeductible IRA, you'll owe taxes only on earnings. On the day you convert, you'll receive a tax bill based on the value of the account that day. Regardless of which type of IRA you have, this could lead to a hefty tax hit.
Unfortunately, you can't use losses from outside the account to offset these gains, as you would with a taxable account. (For more on this, click here.) Since this is a retirement account, your gains are considered ordinary income, not capital gains, and are taxed accordingly, says Joel Isaacson, a certified public accountant and financial planner based in New York.
Nevertheless, assuming you have enough cash outside the account to pay the tax bill, you shouldn't let the tax liability deter you from converting. For investors under age 50, a Roth conversion will usually create more retirement dollars. (To see for yourself, click here.) That's because withdrawals are free of federal income tax as long as the account has been open at least five years by the time you reach 59 1/2. Also, unlike a traditional IRA, there are no rules requiring you to begin taking distributions by age 70 1/2. Moreover, when you pass away, you can pass your Roth on to your children tax-free — making it a superb estate-planning tool. (For more on estate planning with a Roth IRA, read our story.)
Of course, should the market continue to fall, you could wind up owing taxes on gains that no longer exist. Don't panic. By "recharacterizing" the account, you can treat the conversion as if it never happened, thus wiping out your phantom tax liability, says Jim Seidel, editor of RIA's Federal Taxes Weekly Alert. How can that be? Uncle Sam will allow you to convert the original amount in your Roth IRA, minus the losses, back to a traditional IRA via a trustee-to-trustee transfer. And while it's impossible to time the market (particularly in this volatile environment), you have until you file your 2002 taxes to do the recharacterization. If you file for an extension, you could wait until Oct. 15, 2003. This gives the market plenty of time to recover. Once that's done, you can then reconvert the account to a Roth. You'll have to wait until the start of the year following the original conversion or 30 days after the recharacterization — whichever is later.
With these very forgiving rules, converting a traditional IRA to a Roth is a no-brainer for many investors — particularly during a year when account balances are down.