Savers Stick With Roth IRAs Instead of Do-Overs to Cut Tax Bill

Investors aren’t rushing to lower their tax bills by reconverting their Roth IRA accounts to traditional ones ahead of the Oct. 17 deadline.

U.S. savers who switch their traditional IRAs to Roth IRAs must pay taxes up front to get tax-free withdrawals in the future. Those who made the change last year, including wealthy earners who were able to access Roth IRAs after income restrictions were lifted, may have paid taxes on accounts whose current values have decreased. The Standard & Poor’s 500 Index has declined 8.3 percent since its December high.

That doesn’t mean they’re scrambling to go back to traditional individual retirement accounts, said Christine Fahlund, a senior financial planner at Baltimore-based T. Rowe Price Group Inc. Despite the potential tax savings, it doesn’t make sense for all investors to automatically revert, or recharacterize, Fahlund said.

“It’s just simply too complicated,” said Fahlund, whose firm had $520.9 billion in assets under management as of June 30. “Unless you have an accountant that you use regularly, there are lots of details that could go wrong.”

At Boston-based Fidelity Investments, the largest provider of IRAs, the rate of converting back to traditional accounts was about 8 percent this year through August compared with 15 percent a year earlier, according to Michael Shamrell, a spokesman. The majority of recharacterizations took place in the first four months of the year before the market decline, said Ken Hevert, vice president of personal retirement products.

Balanced Portfolios

Vanguard Group Inc., based in Valley Forge, Pennsylvania, said recharacterizations were 3,905 this year through Sept. 21 compared with 4,989 in all of 2010, according to Linda Wolohan, a spokeswoman. Vanguard is the sixth-largest provider of IRAs, based on estimates from Cerulli Associates.

Investors who have balanced portfolios instead of all equities may not have suffered losses and may not want to recharacterize, said Maria Bruno, a senior investment analyst at Vanguard, the largest U.S. mutual-fund manager. Long-term bond funds have returned 7.42 percent this year, data from Morningstar Inc. show.

Only savers who have seen their Roth account values drop by at least 15 percent should consider reverting to traditional IRAs, according to John Burns, a certified financial planner at Burns Advisory Group in Oklahoma City, which has about $600 million in assets under management.

That’s because only losses greater than that justify sacrificing a potential market rise in the 30 days investors must wait before converting to Roth IRAs again and they would recapture those gains in a traditional IRA, Burns said. None of his clients have recharacterized this year, he said.

2010 Changes

One of the reasons clients aren’t rushing to convert back to traditional IRAs and recoup taxes paid is because of a one- time option to report the taxable income from the conversion in 2010, or split it equally between 2011 and 2012, said Fidelity’s Hevert. If they recharacterize their entire accounts now, they’ll lose the ability to defer taxable income if they choose to switch back to a Roth, Hevert said.

Another change in 2010 lifted income restrictions and allowed taxpayers who made more than $100,000 a year in adjusted income to convert to Roth accounts from traditional IRAs, which led to a rise in conversions. Ordinary income-tax rates apply when switches to Roth IRAs are made. Contributions to traditional IRAs generally are tax deferred and taxes are paid when money is withdrawn.

Waiting Period

Unlike traditional IRAs, Roth IRAs don’t require withdrawals once account holders reach 70 1/2. Roths must be held for five years and account holders must be at least 59 1/2 before money can be withdrawn tax-free. Savers who already filed their tax returns in April are still eligible to recharacterize 2010 conversions by Oct. 17. Taxpayers can generally choose to convert or recharacterize a portion of their assets.

Roth IRAs accounted for an estimated $265 billion, or 6 percent, of total IRA assets in 2010, according to the Investment Company Institute, a Washington-based trade group for mutual funds.

Investors may not be rushing to go back to traditional IRAs because of the market volatility and 30-day waiting period before they can convert again to a Roth, said Bruno of Vanguard. For savers who converted in 2010 and are recharacterizing this year, they must wait at least 30 days before switching back to a Roth.

If taxpayers are locked into traditional IRAs and the market increases, they may face higher account balances and higher taxes when they want to convert again than when they originally converted, Bruno said. The S&P 500 Index (SPX) rose 5.1 percent last week.

Face Penalties

There’s also paperwork and calculations involved with recharacterizing that may outweigh the tax savings, Fahlund said. Taxpayers who have filed their April returns may have to file amended returns if they want to recharacterize. If the recharacterization amount isn’t included in the traditional IRA when figuring out required minimum distributions for older taxpayers the following year, they could face penalties if they withdraw too little, Fahlund said.

$5 Million Roths

Recharacterization may be most appropriate for ultra-high- net-worth investors with Roth IRAs of at least $5 million because they stand to recoup more in taxes, said Robert Barbetti, head of the executive compensation practice at the private bank unit of JPMorgan Chase & Co. (JPM) in New York. They also may have more illiquid assets in their Roth IRAs that aren’t likely to rebound during the 30-day holding period, Barbetti said.

A taxpayer in the top income bracket who converted $1 million to a Roth IRA last year would have owed 35 percent or $350,000 in federal taxes, according to an example from J.P. Morgan Private Bank’s Advice Lab. If the Roth IRA had declined in value to $850,000 in September and were recharacterized, and then converted back to a Roth after 30 days without changing in value, taxes owed would be $297,500, or $52,500 less than before recharacterizing.

To contact the reporters on this story: Tania Chen in New York tchen154@bloomberg.net Alexis Leondis in New York aleondis@bloomberg.net

To contact the editor responsible for this story: Rick Levinson at rlevinson2@bloomberg.net.

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