So you listened to the financial experts and dutifully contributed $5,000 to your Roth IRA in early 2008. Unfortunately, stuff hit the fan and now you’re left with a lot less. Wouldn’t it be nice to be able to find some silver lining and shield another ~$1,000 plus earnings from taxes forever?
Well, here’s a slightly controversial idea that I ran across in this Boglehead Forum thread that might help you do just that. I think the easiest way to explain it is to continue with an imaginary scenario. Note that this leaves some variables in exchange for simplicity.
Sometime in early 2008 you contributed $5,000 to your Roth IRA for the 2008 tax year. At the time, your IRA was worth $20,000 in total after the contribution. Now, in January 2009, the entire IRA is now worth $15,000.
You first “undo” your 2008 $5,000 contribution by following the same steps as someone who ended up being ineligible for a Roth IRA due to too much income*. Because your entire IRA account dropped by 25%, your $5,000 contribution is considered to have dropped by the same amount. You end up receiving a check for $3,750. You have received a return of your contribution, and have now technically contributed nothing to your 2008 Roth IRA.
Soon afterward, you simply open up a new IRA either at a new broker, or at your current broker if they are on the ball and have your 2008 total contributions as zero. (Otherwise they might throw a fit…) You can now throw in another $1,250 and contribute $5,000 again to your Roth IRA for the 2008 tax year before April 15th, 2009. Even if you just reinvest the $3,750 the same way as you did before, by using this strategy you have allowed another $1,250 to grow shielded from taxes, forever.
Is This Legal?
This is somewhat similar to the Traditional-to-Roth IRA reconversion method to save taxes. I read some skeptical posts in the BH thread as to the legitimacy of this action, but none were really backed by any evidence. I don’t see why both methods aren’t equally legal.
As another example, you might have made two separate $5,000 contributions by accident, and need to undo one of them. If everything is accounted for correctly by your IRA custodian, the IRS shouldn’t blink an eye. Here is another educated discussion in support of this idea. Other tax pros please add your thoughts in the comments below.
We ended up not being eligible for a Roth IRA this year, but if I was a candidate I think I would take advantage of this idea. In the long run, even stuffing another $1,000 in a Roth could save a lot of money in taxes.
* More information on correcting excess contributions in this Investopedia article. It must be done by the owner’s tax-filing deadline, which usually April 15, 2009 unless you file for an extension. Note that this is not the same as taking a distribution.