Converting a regular individual retirement account to a tax-free Roth IRA seemed like a great idea a year ago, but it caused problems for tens of thousands of people, so the IRS is taking the unusual step of giving them until Dec. 31 to switch the money back to their old IRAs.

Normally, the second income tax extension period would have ended Oct. 15. But the IRS said many of those who converted their IRAs to Roths found out they were ineligible because their incomes exceeded IRS limits or because they were married but filing separately. The IRS said it is sending out letters to 20,000 taxpayers who appear to be ineligible. The tax penalties are harsh, the IRS said, thus the added time.

But the announcement was so broad it will also allow many other people to switch back, even though their only problem may be that the value of the mutual funds or stocks they moved into their IRAs fell.

The process, called "recharacterization," might be valuable to those who may have transferred, say, $75,000 in mutual funds or other securities from a regular IRA into a Roth for the tax advantages, only to find the volatile stock market has reduced the value of those shares considerably. Yet they would still owe taxes on the original $75,000. Until Dec. 31, those people can put the securities back in their original IRA. That sounds like an easy decision, but it may not be.

Let's step back for a moment and see how we got into this mess. The Roth IRA was hailed when it was approved in 1997 because it would allow people to put money in an IRA that could be withdrawn with all profits tax-free after it had been in the account at least five years and when the individual was over 59 1/2--compared with a regular IRA, in which your distributions are taxed. There were income limits--up to $160,000 for a couple filing jointly--but you could open a new Roth IRA until April 15 of the following year, as with any IRA.

The law also allowed those with incomes of less than $100,000 to convert their old IRAs to a Roth. Couples filing separately could not do so because of the government fears that there might be underhanded income shifting that would allow both to convert to Roth IRAs when, if they filed jointly, their income might make them ineligible.

But the real problem was the date. A conversion had to be done by Dec. 31, not April 15. In other words, before people filed their tax returns. Many people who get bonuses or commissions at the end of the year had their final income in doubt but still had to make conversion decisions before they knew.

"The difference in dates is a systematic problem for people," said Nick Kaster, a lawyer and pension analyst with CCH Inc., a tax and benefits information provider in Riverwoods, Ill.

Bob Trinz, editor of Federal Taxes Weekly Alert, published by RIA, a tax information provider in New York City, said the 1998 problem might be the biggest going forward. "Because the IRS allowed you to spread the taxes on conversions out over four years [only in 1998], it will be less of a problem in future years because there will be fewer conversions," he said.

Each conversion is considered a withdrawal, but without the early-withdrawal penalty. From 1999 forward, all the taxes on the withdrawal must be paid in one year, not four.

But there wouldn't have been a problem with income in the first place if the original bill writers had had their way, a Senate aide said. "We came in originally with no income limits, so the problem wouldn't have occurred. But we couldn't get it through." But, he said the chances of getting a bill through this year are slim. He added that there was no chance the IRS or the Treasury Department would switch the conversion date to April 15, which other sources confirmed.

So the decision to recharacterize. If you were not eligible, it is important, because, as the IRS said, you could have to pay "both regular and early distribution taxes on the amounts involved." That early-distribution tax is the 10 percent penalty. The process is complicated, but it should be okay if the paperwork is in order and the company that did the IRA knows what it is doing.

You also will have to amend your 1998 tax return if you recharacterize so you get back the taxes you paid. You have three years to do that, but why lend the government your money? Some people whose stocks have fallen slightly might not want to switch back, hoping they will provide the good long-term returns they bought them for in the first place.

Others might want to keep the four-year tax spread, though Alan Weiner, a partner at Holtz Rubinstein in Melville, N.Y., said "you get the same effect by converting 25 percent of your money at a time," because the money in the old IRA would still be growing tax-free also.

At any rate, check to make sure you were eligible. If you were married and living together but filing separately, you weren't. And if you are planning to convert this year and your income is on the borderline, and uncertain, you may give some consideration as to whether you want to go through this again.

Considerations Before Converting

Here are two scenarios of when a taxpayer might want to "recharacterize," or undo, a Roth individual retirement account:

Income exceeds $100,000, voiding eligibility


Taxpayer took $75,000 from an IRA and converted it to a Roth IRA.

Oct. 15, 1999:

Filed income tax return for 1998 (last possible day to file) and discovered that income exceeds $100,000, making conversion ineligible.

Any time until Dec. 31, 1999:

Recharacterize (undo) Roth IRA: put $75,000 (plus any gains or minus any losses) back into a regular IRA.

File amended return.

Taxpayer will receive a refund of any tax paid on originally filed 1998 return.

The value of converted funds decreases

1998: Taxpayer took $75,000 from an IRA and converted it to a Roth IRA.

Any time in 1999:

Value of Roth IRA declines (say, to $50,000).

Any time until Dec. 31, 1999:

Recharacterize (undo) Roth IRA: put $50,000 back into a regular IRA.

File amended return.

Taxpayer will receive a refund of any tax paid on originally filed 1998 return.NOTE: 1998 conversion income could have been spread over four years