Taxes in 2002: Round-Trip IRA

I think I blew it! I converted my traditional IRA to a Roth account at the beginning of 2001. But since the market fell last year, I find myself with close-to-worthless stocks in my Roth IRA (actually a couple are bankrupt). I now owe taxes on them based on their price at the time of the exchange into the Roth. Is there anything I can do at this time? I hate to think I have to pay taxes on bankrupt stocks that don't trade. Help!Thanks,
Greg

Sorry to hear your investment bit the dust -- but at least as far as taxes go, you can get a break. The Internal Revenue Service allows you to do what's known as a recharacterization of your IRA, which reverses the conversion you did earlier. In other words, you can convert the Roth back to your original traditional IRA.

That way you won't get stuck paying taxes on an investment that has collapsed since you made the conversion. When you convert your IRA from a traditional to a Roth, the IRS assesses income taxes based on the value of your investment at the time of the conversion.

If you didn't switch brokerages when you converted your IRA to a Roth, you may be able to simply designate the account again as a traditional IRA. But if you moved your IRA to another firm, the easiest way to reconvert it is through a trustee-to-trustee transfer. Under this arrangement, "the money goes from Merrill Lynch to Schwab, for example, as opposed to from Merrill Lynch to your pocket," explains Cameron Hess, a lawyer and certified public accountant at the Sacramento, Calif.-based law firm Wagner Kirkman Blaine & Youmans. This way you don't have to worry that money could be withheld for taxes, which could happen if you receive a payout yourself.

You should make the recharacterization by the filing date for the tax year in which your conversion took place. Because you converted to a Roth in 2001, you'd need to recharacterize by April 15 of this year.

But if you miss that date, you can recharacterize by filing an amended return within six months of your original return.

Though you won't have to pay taxes on the reconverted sum, you still have to note that it happened on your tax return. According to the guidebook

Taxes for Dummies

, you should enter the original conversion on line 15a form 1040 or 11a of form 1040A. Then enter "0" on either line 15b of your 1040 or 11b of your 1040A to make clear that you don't owe any tax.

By the way, you also need to recharacterize your IRA if your annual income is above the limit for a Roth conversion, currently $100,000. If you converted a traditional IRA to a Roth early in the year but ended up earning more than $100,000, you should do a recharacterization.

Q: Because I got laid off in January this year, I earned only $2,800 for the tax year. I've already contributed that amount to my Roth IRA. But I want to know if I can contribute another $2,800 to an IRA for my wife, who does not work. The money for her IRA would come from our private savings. Also, as I am over age 50, can I put in an extra $500 for myself and for my wife? -- Walter

In this case, tax law does not reward virtue. Having already opened an IRA for yourself, you're willing to dig into savings to pay for your wife's IRA, but it turns out the government won't let you.

Here's why. If you want to open an IRA for your spouse for 2002, the IRS lets you invest the smaller of two sums:

-- $3,000 ($3,500 if you're over 50), or

-- your income, minus the amount of money you've contributed to an IRA for yourself.

The second rule would apply in your case, because you earned less than $3,500. Unfortunately, because your income was $2,800 and you contributed the entire amount to an IRA for yourself, there's nothing left over to invest for your wife.

But let's step back for a minute and assume you still have the $2,800 in hand -- you haven't yet put it all in your own IRA.

In that case, you could divvy up the $2,800 you earned between an IRA for you and one for your wife, in whatever proportion you like. "You could put in $100 for yourself and $2,700 for your spouse, as long as the total did not exceed $2,800," explains CPA Cameron Hess.

If you wanted to max out Roth contributions for both you and your wife, you'd have to earn at least $7,000 in 2002. This would allow you to open two accounts valued at $3,500 each, assuming both of you are over age 50.

In closing, a few general points on spousal IRAs: The IRS typically lets a taxpayer open an IRA on behalf of an unemployed spouse even if he's enrolled in a retirement plan at work. But if he earns a high income, he can't make the full contribution to a Roth IRA for either himself or his spouse. If his household income is between $150,000 and $160,000 (and the couple files jointly), he can make only a partial contribution. If his income is greater than $160,000, he can't make a Roth contribution at all.

TheStreet.com has a revenue-sharing relationship with Amazon.com under which it receives a portion of the revenue from Amazon purchases by customers directed there from TheStreet.com.