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ROTH Conversions and Recharacterizations


By now you know that I am a big-time fan of Roth IRAs. So much so that I think that any YF&Ber who can convert a traditional IRA, or a SEP-IRA to a Roth IRA should jump at the opportunity.

Remember, when you leave a job you have the option of doing an IRA Rollover in which your 401(k) money is rolled over into an IRA at the discount brokerage or mutual fund company you choose. And you know that I think this is a super-smart move.

When you do the rollover, your 401(k) automatically becomes what is known as a Traditional IRA. That means that when you eventually start making withdrawals in retirement, you will have to pay ordinary income tax on the amount of the withdrawal.

That's where a Roth IRA Conversion comes into play. You can convert your Traditional IRA-as well as a SEP-IRA if you are self employed-into a Roth IRA. The advantage to this move is that when you eventually get around to making withdrawals, there will be absolutely no tax on your withdrawals. Whereas with a 401(k) and non-Roth IRA your withdrawals will be hit with income tax-not even the more advantageous long-term capital gains tax-when you make your withdrawals.

The one catch is that as you convert you need to pay tax on the money that is in the Traditional IRA (or SEP-IRA) before it becomes a Roth. Let me explain the rationale a bit: Remember, the IRS always gets a piece of the action. Since you didn't pay any tax when you contributed to your 401(k) or SEP-IRA-the IRS gets its cut on the back end, when you withdraw the money. But the money in a Roth doesn't get taxed on the back end. So that's why before you proceed from a 401(k), Traditional IRA or SEP into a Roth conversion, you must first stop and pay some tax to the IRS. It's the IRS's sole shot at getting its piece of your retirement pie.

But paying the tax now when you are YF&B is a smart move. First, you are probably in a low tax bracket considering these are your B years, so the bill isn't going to be too onerous. And once you get the tax paid and your retirement stash converted into the Roth you can sit back knowing that all that money will never be hit with tax again. As I explained on page 189 of the book, that can be a huge windfall for the YF&B.

Okay, so here are some basic rules of the road for doing a Roth conversion.

• Your adjusted gross income must be below $100,000 to qualify for a Roth conversion. This $100,000 limit is for both single tax filers and married couples filing a joint return. Yep, this is one instance where there really is a huge penalty for being married.

• You can not use money in your IRA to pay the tax. It must come from some other source.

• To ease your tax bill, you can convert just a portion of your Traditional IRA each year. There is no law that says if you have $10,000 you must convert all $10,000. You can do $5,000 for each of the next two years, or $2,500 for the next four years. Anything goes.

• Contact your discount brokerage or mutual fund company where your Traditional or SEP-IRA is invested and ask for a Roth Conversion form; it's as easy as filling it out and letting the brokerage/fund company take it from there.

• If in the year you do a Roth IRA Conversion you suddenly see your income shoot up past the magic $100,000 eligibility level you will need to reverse your conversion. This is what is known as a Roth Recharacterization.


Even the IRS knows that accidents happen. If you happen to do a Roth IRA Conversion and in that same year your income unexpectedly slips past the $100,000 cutoff for being eligible for the conversion, you need to retrace your steps. This is what is known as a Roth Recharacterization. You are simply converting the Roth back to a Traditional IRA.

Contact the discount brokerage or mutual fund company where your Roth is invested and tell them you need to do a recharacterization. It is not good enough to merely transfer the money from a Roth into a new "regular" IRA account you open. You need to go through some formal recharacterization paperwork.

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