Reversing a Roth IRA Conversion

When it comes to retirment planning, it's easy to make mistakes. If you converted a traditional IRA into a Roth IRA last year before the stock market free fall, for instance, you may be especially forlorn -- most likely your Roth IRA is now worth considerably less than it was on the conversion date. Even worst: You're stuck paying 2008 taxes on phantom value that no longer exists.

Thankfully, you can reverse that ill-advised Roth conversion. In fact, you can make it so it's like the conversion never happened, and as a result, that inflated conversion tax bill will also disappear.

Even better, you have until October 15 to accomplish the reversal. (The deadline applies whether or not you extended filing your 2008 Form 1040 to that date.) However, if you plan to hold stocks in your IRA, and you think the market is headed up from here, you may want to get the reversal done ASAP.

Here's how Roth conversions work:

The tax hit. When you converted your traditional IRA into a Roth account, the trasaction was treated as a taxable distribution from the traditional IRA, followed by a contribution of the distributed amount to the Roth account. So the conversion triggered a federal income tax bill (and possibly a state income tax bill) based on the traditional IRA's value on the conversion date, minus any nondeductible contributions made to that account.

(This assumes that the traditional IRA that you converted was the only one that you owned. If you hold multiple IRAs, the taxable percentage of the converted traditional IRA balance is based on the total balance of all your traditional IRAs and the total of all nondeductible contributions to those accounts.)

Now, thanks to the rocky stock market, that Roth IRA is most likely worth a lot less than it was on the conversion date, which means you've paid 2008 taxes on money you no longer have -- unless you reverse the conversion by the October 15 deadline.

Reporting the reversal. Using Internal Revenue Service lingo, you reverse an ill-advised conversion by "recharacterizing" the Roth account back to traditional IRA status. By doing so, it's like the conversion never happened: The tax hit disappears, and you're right back where you started with no tax harm done. To reverse a conversion, you need to fill out the proper form supplied by the brokerage firm or financial institution that serves as your IRA custodian or trustee.

The custodian or trustee should have reported to you, and to the IRS, the deemed distribution that resulted from last year's Roth conversion on a 2008 Form 1099-R.

Amending your 1040. If you have yet to file your 2008 Form 1040 because you extended filing your return, simply enter the Form 1099-R distribution amount on line 15a. Then enter a taxable amount of zero on line 15b. These two entries will show you had a conversion and a subsequent reversal -- with the net result of zero taxable income.

If you've already filed your 2008 Form 1040, you'll need to file an amended return, using Form 1040X, to show the reversal and collect your rightful tax refund. On line 1 of Form 1040X, subtract the amount of taxable income that was triggered by the now-reversed conversion, and calculate the reduced 2008 tax bill on lines 6-10. Then explain on page 2 of Form 1040X that the changes are due to reversing the 2008 conversion.

Of course, by reversing the conversion in 2009, it will trigger a 2009 Form 1099-R from your IRA custodian or trustee, reporting the deemed distribution from reversing the Roth account back to traditional IRA status. So on this year's Form 1040 (which you'll file next year), you'll enter the Form 1099-R distribution amount on line 15a. Then enter a taxable amount of zero on line 15b. These two entries will show that you had a conversion reversal that did not result in any 2009 taxable income.

Reconverting after a reversal. Converting a traditional IRA into a Roth account can still be a great idea if you get the timing right. Therefore, you might want to reconvert the reversed account from traditional IRA status back into Roth status all over again.

Reconverting makes sense if the account is loaded with assets you believe will appreciate quickly. That way, when all is said and done, you've still converted the same traditional IRA into a Roth, but you've done so at a lower tax cost than when you tried the first time last year.

There is a timing restriction, however. For an account that was originally converted to Roth status in 2008 and then reversed back to traditional IRA status in 2009, you have to wait at least 30 days after the reversal date to reconvert.

Here's an example: Say you orginally converted your traditonal IRA into a Roth in 2008 when the stock market was healthy. Then the account took a big nosedive, so you reverse it back to traditional IRA status on August 1, 2009, to avoid an inflated 2008 tax bill. The earliest you can reconvert the account back into a Roth IRA is August 31, 2009 (30 days after the reversal date.)

Advisors Memorial Day in Jail

I sent the following email out and received some comments back about identifying crooked advisors. So, here is the original email. Afterward will be my follow-up comments.

If you’ve been following the local news, you probably know that Gary Armitage, Jeff Guidi and James Koenig were arrested last Thursday and have spent the Memorial Day weekend in Jail. This will probably be a very memorable weekend for them, not to mention the next 100 years of prison time they’re facing. According to the Press Democrat, they defrauded about 2,000 people out of about $200 million. These guys were supposedly “financial advisors” helping their clients grow their wealth. Over the last 30 years I’ve occasionally run into advisors like this. I can spot them pretty easily—I’m not quite sure why their 2,000 victims couldn’t.

Sometimes I think back about certain clients of mine that have told me they were thinking of hiring Armitage or Guidi instead of me to help them with their investments. What was it that was so appealing about Armitage or Guidi? Why did they ultimately choose to work with me instead of them? What are they thinking—now that the advisors they almost worked with are in jail?

Anyway, these guys belong behind bars for the devastation they’ve caused in the lives of all their clients. There may have been some parties around town last Friday when the news came out—at least some sighs of relief knowing these guys will now face the music. I join those of you celebrating.

For those of you that asked about identifying crooked advisors, I offer the following comments:

1. Find out how they get paid and watch for hints of how that may be influencing their advice to you. Are they really trying their best to help you out -- or their own pocketbook?

2. When I first got into this business, I worked with a guy that represented two different families of mutual funds. The first time he 'sold' someone an investment, he would put them in a fund from family 'A.' The next time he met with that person, he would recommend moving from fund family 'A' to fund family 'B.' He received a sales commission each time he moved the money. Had he just moved the money to a different fund within the same family of funds--there would have been no sales commission. It's in the prospectus.

3. I knew of a financial advisor that went around putting on 'financial planning' seminars. He taught his class and then would do a followup one-on-one consultation with each of the participants. Interestingly enough, his recommendation to each individual, no matter their different circumstances, is that they needed more life insurance and he would happily sell it to them. Insurance was his main line of work--it probably said that on his business card.

4. I know of another advisor that hosts dinner seminars at a local restaurant. He is quite the carismatic, out-going fellow. He could probably sell ice cubes to eskimos. Part of every client investment portfolio was an Equity Indexed Annuity. Why? He got a big sales commission check as soon as the client signed on the dotted line. Ex-clients of his told me that they really liked the guy, but had to admit that he was like a used car salesman. He was always into the 'big picture' and therefore, never fully answered their questions/concerns and left many HOLES in the 'little picture' of their day-to-day financial lives.

5. Do you remember IDC? In the early '80s when inflation was high, International Diamond Corporation came into being down in San Rafael. I was involved with them --briefly. They would sell you on the concept of buying hard-assets as an inflation hedge. They would regularly inflate the prices and send you statements showing the value of your diamonds skyrocketing. People got so excited that they would buy more and tell all their friends to buy some. If you wanted to sell--no problem, there was lots of new cash coming in the door to pay you with. Well, at least until the whole thing came crashing down. They controlled the market. No third-parties were involved.

Now, Gary Armitage...

6. His deals all involved some form of real estate. Real estate company notes, skilled nurings homes, golf courses, college campus, etc. Where is the diversification? How would you feel about holding a portfolio of only bank stocks... or only auto company stocks?

7. He had conflicts of interest in most all of the deals. He was selling the investment and earning a sales commission--as a financial advisor. He was also a general partner or on the board of directors of the companies that the investors were buying into. He was getting compensated on both ends of the deal. This information was in the offering memorandums.

8. The investments he worked with were mostly all illiquid. The investors couldn't get their money back or sell their interest. And, Armitage was perfectly okay with this!?!

9. There was no disinterested, third-party custodian reporting the transaction activity and current fair market values directly to the investors.

10. There was no quarterly performance reporting -- comparing the performance of the client's investment portfolio to the S&P 500 Index, some other Index, or the client's own performance objective.

Well, that's probably enough on this topic. I do really feel horible for those that lost their hard-earned nest-eggs to Armitage and the other scoundrels. I wish there was a way that I could easily restore their investments back to their pre-Armitage days of glory. That's not possible. You know it and I know it. All I can do, with absolute certainty, is to treat each of my clients' investment portfolios as though it was my Mom's. It works for me, and it works for my investment clients too.

... keep in touch, there will be more to follow.

Amazing New Discovery

Lawrence Livermore Laboratories has discovered the heaviest element yet known to science. The new element, Governmentium (symbol=Gv), has one neutron, 25 assistant neutrons, 88 deputy neutrons, and 198 assistant deputy neutrons, giving it an atomic mass of 312. These 312 particles are held together by forces called morons, which are surrounded by vast quantities of lepton-like particles called peons. Since Governmentium has no electrons, it is inert. However, it can be detected, because it impedes every reaction with which it comes into contact. A tiny amount of Governmentium can cause a reaction that would normally take less than a second, to take from 4 days to 4 years to complete. Governmentium has a normal half-life of 2 to 6 years. It does not decay, but instead undergoes a reorganization in which a portion of the assistant neutrons and deputy neutrons exchange places. In fact, Governmentium’s mass will actually increase over time, since each reorganization will cause more morons to become neutrons, forming isodopes. This characteristic of moron promotion leads some scientist to believe that Governmentium is formed whenever morons reach a critical concentration. This hypothetical quantity is referred to as critical morass. When catalyzed with money, Governmentium becomes Administratium (symbol=Ad), an element that radiates just as much energy as Governmentium, since it has half as many peons but twice as many morons.

Funny NEW Financial Terms

3M: Is now 2M.

401(k): Is now 201(k).

Alimony: Two person mistake paid by one.

Budget: Written proof that you can’t afford the things you want.

Bull: What your broker uses to explain why your mutual funds tanked last quarter.

Cash Flow: The movement your money makes as it disappears down the toilet.

CEO: Chief Embezzlement Officer

CFO: Chief Fraud Officer

Diversification: Putting your money under more than one mattress.

Dow Jones: Is now Down Jones.

EBIT: Earnings before irregularities and tampering.

Income Tax: Capital punishment.

Inheritance: Will-gotten gains.

Institutional Investor: Past year investor who is now locked up in a mental institute.

Liquidity: When you open your investment statement and wet your pants.

Loanation: Money given, typically to a close relative, which the provider considers a loan and which the recipient considers a donation.

Market Correction: The day after you buy stocks.

P/E Ratio: The percentage of investors wetting their pants as the market keeps crashing.

Poverty: Having too much month left at the end of the money.

Quarter: A dollar, after taxes.

Social Security: A federally mandated pyramid scheme.

Standard and Poor (S&P): Your life in a nutshell.

Tax Refund: A tactic devised by politicians to give you back some of your own money in such a way that you are supposed to think it’s a gift.

Taxation: An art which consists of plucking the goose to obtain the largest amount of feathers with the least amount of hiss. (Jean Baptiste Colbert)

Knowing Net Worth is Key to Managing Your Money

Grab a pen and a piece of paper and jot down off the top of your head your household net worth. Net worth, in case you are not exactly sure, is the total value of your assets minus your total liabilities.

The first thing to know about your net worth estimate is that it probably is wrong—not just by a few dollars, but by a lot of dollars. Numerous studies have found that families either don’t have any idea what they are worth, or their idea is wrong. For example, a study by Jay Zagorsky, a research scientist at the Center for Human Resource Research at Ohio State University and Boston University School of Management, estimated that 70 percent of households underestimate their net worth, and 25 percent overestimate their wealth.

Furthermore, those who underestimate their wealth do so by nearly 40 percent. For every dollar they are really worth, they think they are worth only 62 cents, and for each dollar their wealth rises, they think they are gaining only 27 cents.

Why should you care about your net worth? Net worth is the best measurement of the state of your financial health. Most of our major spending, investing and other financial decisions are made, or should be, based on our net worth, and obviously the more accurate that estimate, the better. For example, if you overestimate your net worth, you may not save as much as you should for your retirement, or you may overspend based on your perceived wealth. Underestimate your net worth, and you may either save more than necessary for your retirement, take on extra investment risk in the belief you need to make up for what you perceive as insufficient wealth, or buy insufficient insurance coverage.

Calculating an accurate picture of your net worth is relatively easy. Computer programs or worksheets are readily available that run you through the process. Generally, start with how much money you have in checking and savings accounts, U.S. savings bonds (current value), and certificates of deposit and money markets. Add in the current market value of your stocks, bonds, home, real estate investments, retirement plan accounts, individual retirement accounts and business interests. Include the surrender value of your annuities and the cash (surrender) value of your life insurance. And add up the value of your personal belongings: jewelry, automobiles, clothing, furnishings, appliances, collectibles, computers, and so on. Their value should be their current market value—what you could get in cash for the items.

On the liability side, include the mortgage on your home, car loans, student loans, credit-card debt, unpaid taxes, insurance premiums, charitable pledges and outstanding bills. Subtract your liabilities from your assets. That’s your net worth.

Take this measurement every year. It provides a benchmark about how well you are doing. Is your net worth positive or negative, and perhaps more important, is it improving or getting worse? Take a freshly-minted college graduate saddled with student loans. Their net worth is probably negative. They land a job that pays well. They buy a new car, loads of consumer items, maybe even a new home or condo. Current income is enough to pay the bills, but that’s about it. Yet what about their net worth? Unless they’ve made a concerted effort to pay extra toward the student loans, they still have a negative net worth. In fact, the car and house have added to that negative picture. If they aren’t salting away much money in savings and investing, their overall financial health isn’t as sound as their regular income would make it appear.

Use Tax? -- You Gotta' Be Kidding!

You just found a great deal on a new, state-of-the-art computer on the Internet, or you found that big-screen television that you have been searching for day and night. Maybe you are ready for a new book that you plan to purchase by mail order. Possibly you’ve found a new dining table you want to purchase via the telephone. In all of the above situations, California use tax may be due on purchases made from an out-of-state merchant when there is no tax collected by the out-of-state merchant.

The California Board of Equalization administers approximately 30 different tax and fee programs. The best known of these programs involves the sales and use tax. Sales tax applies to purchases made within the state of California. The sales tax counterpart, use tax, applies to purchases made outside the state of California. Sales tax is generally due on the sale of tangible property and is collected by retailers in California at the point of sale. Retailers then remit the sales tax collections directly to the Board of Equalization.

Use tax is sometimes called “sales tax,” but it is actually a separate tax that is generally due on the purchase of tangible property from outside California. If you purchase an item out of state that will be used, consumed, or stored in California, then you owe use tax. If the out-of-state merchant charges you the correct amount of sales or use tax on your purchase, then your use tax requirement has been fulfilled. Out-of-state companies that are “engaged in business” in California must register with the Board of Equalization and collect sales or use tax on their retail sales of personal property to California customers. However, if no sales or use tax was collected on your purchase, you are required to compute and pay the amount of use tax due.

In an effort to assist taxpayers with their use tax reporting requirements, the Franchise Tax Board has included a “use tax” line on the personal income tax return (Form 540). This allows taxpayers the option of reporting their use tax on their individual returns for out-of-state purchases. The other option available for taxpayers is to file a use tax return with the California Board of Equalization (BOE). The use tax return can be obtained online at www.boe.ca.gov and looking for Form BOD 401-DS which is in Publication 79-B.

How do you compute the use tax liability? First, multiply the cost of the property purchased from an out-of-state merchant times the applicable use tax rate. The use tax rate and the sales tax rate are the same. The use tax rate is determined by where the property will be used, consumed, or stored in California. Then, look to determine if any sales or use tax was collected from the out-of-state merchant and subtract this amount from the amount of use tax due.

Here’s a brief example of the calculation: Karen, a Palo Alto resident, bought a TV from computers.com for $1,000. Karen owes $82.20 use fax to California. She may report and pay it on her Form 540 income tax return or on the Form 401 Use Tax Return.

Thank you for being a client—we value your business.

California Tax Refund IOUs

Due to the state’s persistent cash and budget problems, California State Controller John Chiang announced on January 16, 2009, that he will have to delay refunds for 30 days starting February 1, 2009, for Personal Income Tax and Business Entity taxpayers.

If you were counting on receiving a refund early this year, I can recommend some strategies to assist you. If you have withholding from a paycheck, we can file your 2008 return, apply any refund to your 2009 taxes, and adjust your current withholding downward temporarily. In this way, you can “receive” your refund through increased net paychecks over the next few pay periods.

If you choose to wait to receive your refund when the state can begin making payments, I recommend direct deposit to speed your refund when funds are available. Alternately, if you believe the state budget crisis will extend for a prolonged period, but that the state will begin issuing “IOU” warrants, you might find out if your bank will honor these warrants. In the past, banks have cashed California warrants and then collected the funds from the state when available.

Whatever you choose, I also recommend that you let your state legislators know your thoughts about the current state of California’s finances and budget. In your phone book you’ll find a list of contact information for your local members of the California Assembly, California Senators, and Governor Arnold Schwarzenegger.

Thank you for being a client and for your ongoing support.