Partial Conversion May Be the Way to Go With Roth IRA

You've heard it before: Moderation is key.

But that maxim is even more pertinent when we talk about your retirement money.

See Also
Doing the Roth IRA Back Flip

Many conscientious investors converted their traditional individual retirement accounts to the Roth kind last year, thinking they were making a sound move for their retirement. And they were. But they weren't counting on paying ordinary income tax on a converted amount that fell into the toilet.

Fortunately, there is a way to avoid making the same mistake in 2001.

Consider converting your IRA to a Roth a little at a time. This partial conversion will allow you more wiggle room for market mishaps. Why? Because you can undo your original conversion and convert a different amount to the Roth without having to abide by the 30-day rule that says once your recharacterize back to an IRA, you can't reconvert back to the Roth for at least 30 days.

Let's take a walk through the minutiae.

The Roth Rules

When you convert an IRA to a Roth, you will owe ordinary income tax on the amount of the conversion. If you convert your entire IRA account when it is worth $50,000, in, say, January, you will owe tax on $50,000. It does not matter that the account may slip to $25,000 by December. You still owe tax on the $50,000.

To avoid paying tax on an amount that no longer exists, you could recharacterize the account back to an IRA. Then it's as if the original conversion to the Roth never happened. This recharacterization has to happen by the time you file your tax return. Check out our Roth IRA reporting guide for details of how to report your recharacterization on Form 8606 -- Nondeductible IRAs.

That's great, but the idea was to have your money in a Roth for retirement. So now you want to reconvert back to the Roth while your account is down. Then you will owe tax on a smaller converted amount.

True. But thanks to an Internal Revenue Service rule, you have to wait at least 30 days to get back into the Roth. The IRS only allows one IRA-to-Roth-back-to-IRA flip-flop per calendar year to discourage market timing by IRA investors. The official rule says if you've flip-flopped once in a calendar year, you may not convert that amount back to a Roth before either the beginning of the next tax year or 30 days after the amount was recharacterized, whichever is later.

Let's say you converted your traditional IRA to a Roth on June 1, 2000, and recharacterized that then-losing account back to an IRA on Dec. 15, 2000.

Before you could reconvert to the Roth again, you had to check two dates: Jan. 1, 2001 (the beginning of the next tax year) or Jan. 15, 2001 (30 days after you recharacterized). Because you must wait until the later of the two dates, you can't reconvert to the Roth until Jan. 15.

A big heads-up: Recharacterizing early in the year keeps you out of the Roth longer. If you converted to the Roth in January, then decided to flip back to your IRA in February, you'd have to wait until Jan. 1, 2002, to get back to the Roth.

2001 Conversion Odyssey

If you're thinking about converting your IRA to a Roth in 2001, check the account's current standing.

Has it been pulverized, thanks to your overweighted tech position? Then by all means, consider converting the entire account. You will owe ordinary income tax on the converted amount. Let's hope the account won't go any lower, so you've maximized your tax situation.

(Note: Your conversion will count for 2001. Your last day to convert to the Roth for 2000 was Dec. 29, since Dec. 31 was a Sunday.)

But if your IRA account somehow managed to stay in good condition, you might consider doing a partial conversion, since it's easier to undo if the market tanks again in 2001 and your account gets tackled.

Let's say you have a $50,000 IRA and you convert only $25,000 to a Roth. Then -- surprise! -- the market tanks and now your Roth is worth $10,000. You still owe tax on $25,000 though. To avoid that big tax hit, you recharacterize back to an IRA and undo the Roth.

But don't you have to wait 30 days to get your money back into the Roth?

Not necessarily. Like all good rules, our tax pros have found a way around this one too.

This 30-day rule applies only to the actual amount originally converted. It does not apply to amounts that haven't been converted.

So instead of having to wait at least 30 days to get back in the Roth, you can convert the other $25,000 -- the amount that originally was left in your IRA -- to the Roth. Since this amount has never been converted before, you did not break the rule.

This partial conversion may be useful for you, because the market has been so unstable lately. If the market does tank after you've converted an amount to the Roth, at least you can undo it and minimize your tax hit by converting an entirely different amount.

Here's a tip: When you undo your original Roth conversion, consider rolling that amount into a different traditional IRA. This will keep your funds separate, further solidifying that you are dealing with two different amounts of money.

Even better, Maggie Doedtman, manager of tax training at H&R Block in Kansas City, Mo., suggests converting both amounts first, then recharacterizing the original amount back.

In our example, before you recharacterize the original $25,000 that has lost value back to a new separate IRA, first convert the untouched $25,000 that's still in your IRA to the Roth. Then recharacterize the first $25,000 out into a separate IRA. "By converting the second block before recharacterizing the first block, there's no question of the 30-day rule being an issue," says Doedtman.

Granted, like all loopholes, this one too will be closed eventually. But for now, consider using it as a hedge against this precarious market.

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