The economic meltdown over the past year tested the stamina of every investor. Though the financial markets show some signs of recovery, uncertainty continues as the world’s economies regain strength. Many people have been concerned about the decline in value of their retirement assets. Some may have yet to re-enter the markets after cutting earlier losses. There is a way to turn a market loss into a “tax win”—consider a Roth IRA conversion.

Building retirement wealth with a Roth IRA

• Tax-free growth potential
• No mandatory withdrawals
• Tax diversification
• Greater control over your financial legacy
• Estate trimming opportunities

Converting lower asset values means less taxes

Your IRA account value may have gone down, but so has the cost of a Roth IRA conversion. The cost equals the ordinary income taxes you must pay on the total amount converted in a tax year. Ideally, you should pay conversion taxes using non-IRA money. The lower your Traditional IRA account balance, the lower your tax bill. This can be a significant savings, particularly if you’re in a higher tax bracket. That can make a bear market an opportune time to convert to a Roth IRA. Additionally, if you believe tax rates are likely to increase in order to fund economic stimulus programs, the prospect of converting sooner with lower taxes and lower rates may be attractive.

Bear market vs. bull market conversions

Consider this hypothetical example of an investor who converts to a Roth IRA during a stock market boom. If the Traditional IRA is valued at $100,000 and the investor’s tax rate is 25%, the conversion tax bill amounts to $25,000. However, if the same investor converts after a market downturn, in which the Traditional IRA is worth only $50,000, the resulting tax liability is a more palatable $12,500. The investor not only enjoys lower conversion taxes compared to a bull market conversion, but those retirement assets now have the potential for future tax-free growth and withdrawals.¹ Your converted Roth IRA earnings can grow tax-free and earnings can be withdrawn tax-free if you hold the conversion contribution for at least five years and you are age 59½ or older. Earnings can also be withdrawn tax and penalty free if they meet one of the other qualified distribution requirements (death, disability, and qualified first time homebuyer expenses up to $10,000 limit) and were held for at least 5 years.

Decreased-value conversions and tax brackets

There’s another incentive to convert if your IRA values have decreased. If you’re concerned that a conversion will lift your reportable income over the threshold of your current tax bracket, that is less likely to occur if your Traditional IRA has underperformed. If you convert after your account has lost value, you may be able to convert most or all of your Traditional IRA assets. Plus, for 2010 conversions only, you have a special option to divide your taxable income on the conversion equally among tax years 2011 and 2012, spreading out your tax liability. If your conversion still raises your taxable income to the next bracket, consider making a partial conversion of only the amount that stays within your current bracket.

Recharacterize if you change your mind

If you’re uncomfortable with the tax liability even after converting market-reduced assets, you can elect a “do-over” in the form of a recharacterization. This is also a valuable option in the event the market underperforms following your conversion. The recharacterization process enables you to undo a full or partial conversion (including earnings/losses) and revert back to a Traditional IRA, thereby, negating your conversion tax bill. Current tax laws allow you to recharacterize by October 15 of the year following a conversion.² For example, if you converted $50,000 in January, 2009, and the market value of your Roth IRA declined to $25,000 by December, you’d still owe taxes on the original $50,000 conversion amount at tax time. To avoid paying that hefty tax bill on the conversion that’s lost half of its value, you can recharacterize by October 15, 2010 (calendar year taxpayers) and no longer owe conversion taxes.

Talk it out with your advisors

Roth IRA conversions and recharacterizations involve careful planning and execution. That’s why it’s critical to meet with your tax and financial professionals to discuss how a Roth IRA conversion may fit into your individual financial plan.

¹ This hypothetical example is for illustrative purposes only. Individual exemptions and other factors impact taxation. Consult your tax advisor for complete details.

² The IRS issued Announcement 99-57 that automatically extends the deadline to recharacterize Roth IRA conversions until October 15 (calendar year taxpayers), even if you filed your tax return by April 15 without applying for an extension. A recharacterized IRA cannot be converted again in the same year as the original conversion or within 30 days of the recharacterization. Your tax advisor can provide more information.

To learn more about strategies for retirement, including commentary from Thomas Rowley, IRA calculators, and additional information on traditional and Roth IRAs, please visit us here.

Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. It was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. federal tax laws. Federal and state tax laws are complex and changes frequently. You should always consult your own legal or tax advisor for information concerning your individual situation.

The information provided is based on tax laws currently in effect, which are subject to change. There is a possibility that this tax legislation will be amended or repealed in the future. In that case, the outcome of a Roth conversion may not be advantageous. Additionally, a Roth IRA conversion may not be suitable for your specific circumstances now or in the future.

IRA owners are encouraged to seek the advice of an attorney or tax advisor that specializes in this area.

The opinions in this piece are not necessarily those of Invesco. Information in this report does not pertain to any Invesco product and is not a solicitation for any product.