Q: In January, 2000, my wife and I each invested $2,000 in zero-coupon Treasury bonds for our Roth IRA accounts. A year later, we find that we did better than expected, and our adjusted gross income of $153,000 disqualifies part of our contribution. Is there any option open to us other than liquidating the bonds and withdrawing the excess contribution? -- J.B., New York
A: With the way things went in the market last year, doing better than you expected puts you ahead of many investors. The
Roth IRA, designed to protect aftertax investments from capital gain and interest income taxes, does not hold much appeal for investors facing capital losses. But, since you came out ahead last year, you have reason to keep your Roth IRA. Depending on how you handle the situation, you may not need to sell the bonds -- or take a taxable distribution.
THREE CHOICES. You have three options when you contribute an amount over the allowable limit: leave it, withdraw it, or recharacterize it. Leaving it in your Roth IRA means the IRS charges you a 6% excise tax on the excess contribution for every year your Roth account is overfunded. You can apply this year's excess to next year's contribution, but you'll still have to pay the excise tax on it for this year. That means paying taxes you could avoid.
Withdrawal is a second option, but not necessarily a better one. A withdrawal from any kind of IRA is a taxable event. The IRS allows you to take back the amount of the excess contribution tax-free, but you must report any increase in the value of the account as taxable income. You also pay a 10% early withdrawal penalty.
Many people make a withdrawal because they don't know about the third, best option: recharacterization. It's an ugly word only an IRS bureaucrat could love, but it simply means switching money from a Roth IRA to a traditional IRA. You have until your tax return is due to recharacterize this year's Roth IRA contributions as traditional IRA contributions. If you have already filed your return, you can still recharacterize by
filing an amended return within six months of the due date of the return.
TAX-EFFICIENT. If you've made an excess contribution to your Roth IRA, hands down, recharacterization is the best way to go. It allows you to keep the contribution in a relatively tax-efficient vehicle. "While a Roth IRA offers tax-free growth and a traditional IRA offers tax-deferred, [how much you contribute to each] depends on an individual's personal situation," says Ed O'Connor, director of retirement and education savings at Merrill Lynch. If it's a choice between paying taxes or deferring them, clearly recharacterization is the best way to go.
Recharacterization is not subject to the one-year waiting period between rollovers that 401(k)s are. The nondeductible IRA contribution that you make through the recharacterization carries the date of the original Roth contribution, so it
preserves your capital gains from that point in time.
Of course there are limits to its use. Starting in tax year 2000, "you may not reconvert an amount previously converted and recharacterized," according to an IRA publication issued by Muriel Siebert & Co. Recharacterization allows a taxpayer to
rectify a mistake made within one tax year, but after that, the change stays permanent. If you overcontribute to your Roth IRA next year, you can do it again with the new amount, but making an annual habit of recharacterization will put up a red flag for the IRS.
Ever loath to neglect a nuance, the IRS requires that you also recharacterize the earnings attributable to the excess contribution that have accumulated in the account over the course of the year. Often, the trustee will calculate this number for you. For do-it-yourselfers, the IRS provides a form, Notice 2000-39, that explains the approved method of calculating transfer amounts. In a nutshell, you multiply your
yearly earnings in the account by the proportion the market value of your contribution represents of your account's total market value.
GETTING IT DONE. The nitty-gritty of the process occurs through a trustee-to-trustee transfer. You need to call the trustee of the Roth IRA, be it a banker or broker, and request this transfer. If you are moving the securities to another institution, be sure to notify both trustees ahead of time about the transfer. Tell them the type and amount of the excess contribution, the date you made the first contribution and the year for which it was made.
Of course, the IRS will need to hear about the recharacterization. Report it on Form 8606, which is used to report nondeductible IRAs. For more information on Roth IRAs
and recharacterizations, see IRS Publication 590, or go to www.rothira.com.
You also may want to consult your trustee or tax adviser before beginning the switch. If executed incorrectly, your trustee-to-trustee transfer will be treated as a failed conversion, and that will cost you. Unfortunately, you probably won't get much
sympathy from the rest of us who are paying tax on depreciated Roth IRA contributions.
Do you ever get the feeling you could be doing something a lot smarter with your money? Do you know how to navigate the tricky currents of home-equity loans and mortgages? Ever worry about whether you've got the right insurance, or if your accountant is minimizing your tax bite as much as possible?
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Please include your real name and phone number in case we need more information. If we use your question, only your initials and city will be given. Because of the volume of mail, we won't be able to respond to all questions personally. Questions may be edited for length and clarity. By Kathleen Turner Starr