CCH Says The Bear Market May Be Good Time To Convert To A ROTH IRA

(RIVERWOODS, ILL., February 26, 2003) – Continued declines in the stock market have left many investors with significantly diminished retirement portfolios. While some individuals may not even want to look at their statements, given the state of their holdings, there are tax benefits that can be reaped by making adjustments to even the most tattered retirement portfolios, according to CCH INCORPORATED (CCH), a leading provider of tax, pension and business law information.

In addition to the need to diversify and rebalance, which became apparent during the past few years, individuals may want to consider other changes as well, including converting from a traditional IRA to a Roth IRA and rolling over IRAs into an employer-sponsored plan or vice-versa. Those already taking distributions from their retirement accounts also may benefit from recent changes to IRS regulations that provide more flexibility in minimum and early distribution rules.

Converting to a Roth IRA

Procrastination may have paid off for those who sat on the fence the last few years trying to decide whether or not to convert their traditional IRAs to Roth IRAs.

"For all the reasons that, in retrospect, a conversion from a traditional to a Roth IRA three years ago turned out to be a bad decision for many, doing a conversion in today’s climate could end up being advantageous," said CCH senior pension law analyst Nicholas Kaster, JD, author of Saving for the Future: Roth and Traditional IRAs.

Someone who converted at the height of the stock market boom and has an IRA that was heavily invested in equities, particularly tech stocks, ended up paying conversion taxes based on the high values of those investments. Fast-forward to January 2003, and the value of that individual’s account today may have declined by 50 percent or more. So, the decision to convert at that time was costly from a tax standpoint.

On the other hand, the onset of a bear market may present opportunities for those who haven’t done a conversion. With the value of their retirement accounts near bottom, they could reap a double benefit: taxation on the value of the account while it is still low, and – assuming equities rebound – tax-free distribution of a higher account balance in the future.

"Roth IRAs aren’t for everyone, but if the cost of converting – essentially paying the taxes on the amount being converted – was what was holding you back and if the value of your portfolio has declined, the conversion costs have declined as well," said Kaster.

To be eligible to convert a traditional IRA to a Roth IRA, your adjusted gross income (AGI) must be less than $100,000. If you make a conversion and it turns out your income exceeds the limit, it’s then considered a failed conversion and the funds have to be put back in the traditional IRA. You can recover any tax you paid on the conversion by filing an amended return.

If you change your mind about a conversion, you can make one "recharacterization" back to a traditional IRA in a given tax year. You then have to wait until the next tax year before making a "re-conversion" back to a Roth IRA. In addition, at year-end, a 31-day period must pass between recharacterization and re-conversion, meaning you can’t make one move on December 31 and an opposite one on January 1. Limitations designed to prevent individuals from making repetitive changes back and forth to whittle down their tax bill for conversions apply.

For instance, say you decide in February to convert a traditional deductible IRA valued at $20,000 to a Roth IRA. You’re in the 27-percent bracket, so you’d owe $5,400 on your next tax return. But then the stock market declines further and along with it your Roth account. By September, the $20,000 is only worth $16,000.

Had you waited to make the initial conversion until your account was worth only $16,000, the tax on the conversion would have been only $4,320.

You could do a recharacterization at this point – switching the money back to a traditional IRA and escaping the tax on conversion. However, if you then decide you want to have the money in a Roth after all, you’ll have to wait until the next year to make the switch again.

Rolling Over an IRA to an Employer-sponsored Plan

"Individuals who have been accumulating different retirement accounts over the years also may want to consider taking advantage of recent changes that allow them to roll over IRA assets into employer plans and vice-versa," notes CCH pension law analyst Glenn Sulzer, JD.

Under changes to the tax code that went into effect in 2002, individuals can roll over distributions from an IRA into a 401(k), 403(b) or 457 plan, or roll over assets from a qualified plan into an IRA. However, nondeductible contributions made to a traditional or Roth IRA are ineligible for rollover to a qualified plan.

"This provision adds flexibility and offers potential simplicity for savers wishing to consolidate their retirement savings in a single location," according to Sulzer. However, he cautions that 401(k) plan assets may not be rolled over to a Roth IRA. Distributions from a 401(k) plan must be first rolled over to a traditional IRA and then converted to a Roth IRA.

Additionally, most 401(k) plans also offer a loan option to participants. Therefore, an IRA-to-401(k) rollover provides the opportunity for individuals to access the funds in their retirement accounts via a loan rather than taking a distribution, which may be subject to the 10-percent early withdrawal penalty.

But rolling over assets from an IRA to an employer plan can have drawbacks as well. Your investment choices in a qualified plan are limited to what the employer wants to make available under the plan, whereas IRA owners have a wide array of investment options from which to choose. Also, funds transferred will be subject to any restrictions contained in the transferee plan on changing investment options. Also, tax law imposes certain rules on qualified plan withdrawals that don’t apply to IRAs; for instance, the requirement that plan distributions be taken as a joint and survivor annuity if the participant is married and no waiver is filed.

Cashing Out of Your Retirement Accounts

While many individuals may be dismayed at the current state of their retirement portfolios, cashing out and starting all over is generally not the best approach.

You may be able to achieve a loss on your current return, but the long-term downside is that the remaining money, no matter how much it has shrunk, is no longer in a retirement account and it no longer enjoys tax-deferred status.

In most instances, an IRA that has been funded over several years is still likely to be worth more than the basis – or what the individual actually contributed to the account – despite the stock market’s recent poor performance. However, someone who established an account recently and invested aggressively during the stock market bubble could be holding an account that is now worth less than his or her basis.

Say, for example, you opened a Roth IRA four years ago and contributed $2,000 to the account each year, investing almost entirely in technology stock. Your basis is $8,000, but the value of the account has now shrunk to $5,000 – or $3,000 less than your contributions. You may be able to dissolve the Roth and declare a loss of $3,000 on your current income tax return. The loss would appear as a miscellaneous itemized deduction on Schedule A, and it could only be taken if the total of your miscellaneous itemized deductions exceeded 2 percent of your AGI.

However, if you decided to claim a loss on this Roth IRA account, IRS guidelines require that you liquidate all Roth IRA accounts you hold. Likewise, if the account you want to close out is a traditional IRA, then you’re required to liquidate all your traditional IRA accounts. You’re also now holding $5,000 that is no longer working toward your retirement.

Retirees Now Taking Advantage of New Flexibility in IRS Distribution Rules

For individuals who have already retired and are taking required distributions or for those taking early distributions from their traditional IRAs or employer-sponsored plans, the IRS has issued new regulations easing the distribution requirements.

Under existing law, individuals are required to start taking distributions from traditional IRAs at age 70½. Participants in 401(k) plans are also required to start taking distributions at that age or once they retire, whichever comes last. While these distributions are still required, the IRS released final regulations in 2002 that make determining the required distribution amount vastly simpler.

Under the new regulations, for each yearly distribution, retirees, in most cases, simply divide the account balance at the end of the previous year by a number from a life expectancy table. Because the new table is based on longer life expectancies, it produces lower required distributions.

The IRS also as adopted new rules that help individuals -- who began taking early distributions from their retirement savings -- cope when there’s an unexpected drop in the value of their retirement accounts, as has been the case for many early retirees in recent years.

While taxpayers are generally subject to a 10-percent additional tax on amounts withdrawn from IRAs or employer-sponsored individual account plans prior to attaining age 59½, the IRS allows an exception when they take distributions as part of a series of "substantially equal periodic payments" over their life expectancy.

The IRS provides three safe-harbor methods for satisfying these criteria. However, two of these methods – annuity and amortization – result in a fixed amount that must be distributed and that could cause the premature depletion of the account when there’s a significant decline in the account’s market value.

Previously, once an individual chose the distribution method, she was required to continue to use that method or face significant penalties. Given the nose-dive in the stock market, the IRS is now allowing individuals a one-time chance to change without penalty from the annuity or amortization method to the minimum distribution method, which calculates the amount that needs to be withdrawn each year based on the current value of the account. This is particular relief for individuals who took early retirement during the stock market rally but who now see their retirement savings depleting far quicker than they’d anticipated.

An example of this would be an individual who retired in 1999 at age 55. He had $500,000 in his 401(k) plan and wanted to start accessing the funds immediately. He chose the amortization method to satisfy the substantially equal periodic payments. Based on the value of the account at that time and its expected growth, it was determined he should take out a fixed sum, hypothetically $28,000 annually for the next 25 years to satisfy the substantially equal periodic payment requirements for early distribution.

Three years later, the stock market bottomed out and his retirement account is only worth $250,000. He is still required to take out the $28,000 annually under the amortization schedule, depleting his retirement funds far faster than anticipated. Under the new IRS rule, however, he now can switch to the minimum distribution method, allowing him to take smaller payments and preserve his account longer because it’s based on dividing the balance in the account the previous year by the number of years he’s expected to live based on the new, more generous, life expectancy table the IRS also adopted last year.

The revised early distribution regulations became effective in 2002, and there’s no time limit by which individuals need to change methods. However, it is a one-time offer. If an individual later decides he or she wants to change methods yet again, the IRS will consider that a modification and penalties will apply. In addition, note that the relief does not apply to individuals age 70½ or older who must continue to take specific minimum distributions even though the value of their assets have eroded.


CCH INCORPORATED, headquartered in Riverwoods, Ill., was founded in 1913 and has served four generations of business professionals and their clients. CCH is a Wolters Kluwer company. The CCH tax and accounting destination site can be accessed at

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Editor’s Note: Members of the media who would like a complimentary review copy of Saving for the Future: Roth and Traditional IRAs may contact Leslie Bonacum at (847) 267-7153 or