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A 'Roth mulligan' just might be worth a shot

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Sunday, September 12, 2010

If you have a high income, you've probably been particularly frustrated that your earnings level meant you couldn't put money in a Roth IRA, which has some fabulous perks.

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Go to any retirement savings seminar and you'll find that a Roth individual retirement account is all the rage because, unlike a traditional retirement account, there is no minimum withdrawal requirement at age 70 1/2 . And best of all, because Roth IRA contributions are taxed going in, withdrawals are not taxed coming out (as long as you meet certain holding requirements).

But earn too much and you are shut out from contributing to a Roth. This year, a back door to Roth investing was opened for high earners. As of Jan. 1, there will be no income limits for investors who want to convert a traditional IRA to a Roth IRA. It used to be that only taxpayers with modified gross incomes of $100,000 or less were allowed to convert.

Please be clear on this. Although the conversion rules have been relaxed, there is still an income-eligibility limit on contributions to a Roth IRA.

If you do go for a conversion, you will have to pay income taxes on the pretax contributions and earnings that are converted. The amount of tax you pay is based on your current tax bracket, but that's the trade-off for tax-free withdrawals later in retirement (contributions to a Roth IRA are not tax-deductible). You can convert part or all of the money you've put in a traditional IRA. (Get advice from a tax professional about when the taxes are due.)

But what if you've converted from a traditional IRA to a Roth and then the value of your investments drops? Considering the year we've had in the stock market, that's a great possibility. You might be saying to yourself, "Oh shoot. If I had only waited I would have paid less taxes on the conversion."

Well, in the Roth conversion world, you have an opportunity to undo what you did. Call it a Roth mulligan.

This redo, or recharacterization, allows an investor to reverse amounts converted from a traditional IRA to a Roth IRA. But there's a deadline for this action. You have until Oct. 15 of the year following a conversion to recharacterize. Fidelity Investments released survey results recently that found only about a third of investors who are eligible for a Roth IRA recharacterization are aware they can undo the conversion.

It didn't surprise me that people aren't aware of this option. Heck, it's difficult enough keeping track of the basics of investing in a traditional IRA or Roth. My head hurts trying to figure this all out.

Fidelity has put on its Web site (http://www.fidelity.com/rothconversion) a very helpful article that lists some reasons you might consider a Roth mulligan. For example, your taxable income in retirement might have dropped this year or you find that you can't pay the taxes from the Roth conversion.

When you to go to the site, look on the right-hand side for "Fidelity Viewpoints." Click on the link for "How to reverse a Roth IRA conversion."

If you aren't sure you should convert in the first place, you might also ask for help from your investment adviser or the company where you have your IRA. Converting to a Roth may seem like a slam-dunk but it's not. There are pros and cons. Here are some things to consider before converting, according to Fidelity:


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