Lowering Your Tax Hit from a Roth IRA

Sharon Epperson | @sharon_epperson

Published 10:34 AM ET Wed, 14 July 2010 CNBC.com

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The tax-free growth offered by a Roth IRA can help stretch retirement savings—and that's good news for all Americans, half of whom are at risk of running out of retirement money.

Those retirement savings-deficit Americans include both late Baby Boomers, who are now 56 to 62 years old, GenXers, ages 36 to 45, and others in between, according to a report released Tuesday by the Employee Benefits Research Institute.

Roth IRAs have become a compelling retirement vehicle for many investors who could never qualify for them in the past. Starting this year, there are no income restrictions for converting a regular IRA to a Roth.

But a Roth IRA conversion done this spring, when stocks were at their 2010 highs, may have left you with a bigger upfront tax hit than your current balance would warrant. Don't worry, you may have an out.

Doug Bramley, a 37-year-old attorney from Manasquan, N.J., is reconsidering his switch from a regular to a Roth IRA earlier this year. He hasn't seen a huge decline in the value of his Roth portfolio, but he realizes his tax hit is based on a balance that was about 7 percent higher than where it is today. So he's talking to his financial advisor about his options.

"We're considering right now whether or not we should go ahead and 'recharacterize' it back to a traditional IRA," Bramley said.

By "recharacterizing" a Roth, you can reverse that conversion and the resulting tax bill, said Bankrate.com's senior financial analyst Greg McBride. "What you're essentially doing is pressing the rewind button and undoing that conversion as if it never happened."

You can still convert to a Roth again, but you'll have to wait until the next calendar year.

Another strategy: If you're worried about market volatility and want to limit your tax hit even more, then convert your IRA into a Roth one piece at a time. "Split the conversion among 3, 4, 5 accounts," McBride suggested. Then you can pick and choose which investments to later recharacterize to a regular Roth.

Converting chunks of your IRA to a Roth may also be a way around the income limits on contributions too. If you make more than $120,000 a year ($177,000 for joint filers), you can't add any more money to a Roth IRA. So open a regular, nondeductible IRA and convert it into a Roth, a little bit at a time.