What to Do with a Ravaged IRA

Try changing it to a Roth.

Finally, your chance to do what your mother always told you: Make the best of a bad situation. With investments shrunken to Alice in Wonderland size, now could be your opportunity to convert your traditional individual retirement account to a Roth IRA. Or, if you converted to a Roth when the market was higher, you can avoid taxes rung up during that transaction.

Roths come with that rarest of benefits--tax-free appreciation. You can't deduct your annual contribution--up to $3,000, or $3,500 for those 50 and older--as with a traditional IRA. But unlike the traditional, you owe no taxes when you pull out the money in retirement.

While you can take your money from an old IRA and pour it into one of the newer Roths, you'll owe taxes on the amount converted, since it gets added to your income. But with portfolios ravaged, "it's like a half-off sale," says Ed Slott, publisher of Ed Slott's IRA Advisor. An IRA that has plunged from $100,000 to $60,000 will cost a lot less to convert than it would have before.

The biggest hurdle is you can't convert at all if your modified adjusted gross income tops $100,000 (for either a single person or a married couple). Even if you're eligible, you may decide you can't afford to--especially if the jump in income makes you lose out on other tax deductions, triggers taxes on your Social Security benefits, or pushes you into the alternative minimum tax system.

You also have to decide if a Roth is best for you. Generally, the longer until retirement, the more the Roth's tax-free vs. a traditional IRA's tax-deferred appreciation matters, says Bob Scharin, editor of RIA's Practical Tax Strategies, a magazine for tax pros. Also, if you think your tax rate will remain high after you retire, a Roth becomes more alluring. Tools at vanguard.com, kiplinger.com, and businessweek.com can help.

There is a flip side to this strategy. Those who acted last year, or even earlier this year, may have converter's remorse if their investments have fallen further. If you converted this year, you have until Oct. 15, 2003, to change your mind and put the money back in a traditional IRA, wiping out your tax bill.

If you converted in 2001, you still could empty the Roth and claim the loss as a miscellaneous deduction. This is only worth doing if your Roth is so small you won't mind losing it as a retirement vehicle, and if the loss is high enough to meet the 2% adjusted gross income threshold for claiming miscellaneous deductions. You don't want to close out your Roth and reap no tax benefit. Or, as your mother would say: Look before you leap.

By Carol Marie Cropper

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