When the value of your portfolio is down, there can be an opportunity to save on taxes using a Roth IRA. Take a look at two options:

No Income Limit for Roth Conversions

    Before 2010, an individual with modified adjusted gross income (MAGI) above $100,000 could not convert a traditional IRA into a Roth IRA. The MAGI limitation was eliminated beginning January 1, 2010 so anyone can now convert to a Roth, regardless of income.

    Don't worry about making a decision that's set in stone. Uncle Sam gives you the flexibility to convert to a Roth IRA, "unconvert" to lower your tax bill if the stock market drops, and then convert back again.

1. Consider converting your regular IRA to a Roth IRA if the value has decreased. Since you pay taxes based on what the account is currently worth, the tax cost to convert is lower when the value of your IRA is down.

  2. On the other hand, if you converted your traditional IRA to a Roth and the value of the account has now dropped considerably, it may pay to undo the conversion.

The rules are complex, so let's start with the basics.

With a Roth IRA, contributions aren't tax deductible but withdrawals are tax-free after five years, as long as you're age 59 1/2 or older. In addition, you don't have to take required distributions from a Roth IRA after age 70 1/2 so your money can keep growing tax-free for decades.

In contrast, with a regular, deductible IRA, you get an upfront deduction for contributions but you must begin taking taxable mandatory withdrawals after you turn 70 1/2.

So converting a regular IRA to a Roth IRA can pay off in future tax-free income. However, the conversion is considered a liquidation of your original IRA so you owe tax on the amount withdrawn and placed in a Roth account.

The Market Effect

If your IRA is devalued, it might make sense to convert to a Roth IRA because the tax bill will be lower. Suppose, for example, you rolled over your $500,000 retirement plan balance into an IRA. Now you want to convert to a Roth account. Assuming a combined federal and state tax bracket of 40 percent, converting your $500,000 IRA to a Roth IRA will trigger a $200,000 tax obligation (40 percent times $500,000).

But if a bear market cuts the value of your IRA to $400,000, you only owe $160,000 on a conversion (40 percent times $400,000). In this example, you save $40,000 by converting after a market dip.

What if you converted to a Roth IRA last year when your IRA was worth $500,000? Now your investments in your Roth account are only worth $400,000 and you already paid $200,000 in tax? You may be able to change your mind and collect a refund by undoing the conversion by the deadline. (The IRS calls this "recharacterizing.")

To undo a 2012 Roth IRA conversion, contact the trustee of your Roth IRA to have the money rolled back into a traditional IRA by October 15, 2013. Then, file an amended tax return using IRS Form 1040X.

If you undo a conversion, it doesn't mean you're shut out of a Roth IRA forever. Once you recharacterize to a regular IRA, you can switch back or "reconvert" to a Roth IRA in the future and owe a lower tax bill. But you have to wait 30 days after the recharacterization.

Tip: When converting to a Roth account, pay the tax bill with non-IRA funds, if possible. The more money you keep in your IRA, the greater the tax-free buildup you'll eventually be able to enjoy.

And if you do convert, keep in mind that the additional conversion income will increase your AGI. That could disqualify you for other tax-saving deductions, credits and exemptions or make more of your Social Security benefits taxable.

The Roth rules are tricky so consult with your tax pro to determine the effect of any decisions and ensure the best results for your retirement funds.

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