The ins and outs of owning a losing investment in an IRA.

• Author: Weiner, Alan E.
• Position: Individual retirement account

Sometimes an investment held in a taxpayer's traditional individual retirement account (IRA) does not pan out. Instead of rising in value as the taxpayer had hoped, it tanks. But the taxpayer still hopes that it will rise again and does not plan to sell it. Here is a way to turn a lemon into lemonade (with a little help from the stock market). It might be a "push," but taking the suggested steps is a no-lose proposition.

The ingredients: The taxpayer has a traditional IRA; the traditional IRA purchased a stock or bond that has decreased significantly in value; the taxpayer expects it to increase in value over time, so the taxpayer will not be selling it; the taxpayer has or can start a Roth IRA; and the taxpayer does not mind a little paperwork.

Example 1: The taxpayer purchased R Corp. stock in the taxpayer's IRA for $25,000, but the stock now is worth $5,000. The taxpayer believes in R and does not want to sell the stock. The taxpayer is over age 59%. The taxpayer has the stock transferred to the taxpayer's Roth IRA on June 27, 2016.

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The taxpayer will incur a 2016 income tax on $5,000. Years later, the R stock increases in value to $18,000, and the Roth IRA sells it. Under current law, the $13,000 never will be subject to federal income tax no matter when it is withdrawn from the Roth IRA. Had the taxpayer left the R stock in the traditional IRA and sold it in that IRA, ultimately, when distributions were made from that IRA, the taxpayer (or the beneficiaries) would pay ordinary income tax.

Alerts

The IRA area is replete with traps and pitfalls. For example, to avoid unwanted income tax consequences and penalties, as a general rule, the Roth IRA owner must be over 59% at the time of the distribution of income, and the Roth IRA must have existed for five years before earnings can be taken out tax-free.

Be aware that a second five-year period applies to a conversion, i.e., a new five-year period starts at the time of every Roth conversion. Note that the second five-year rule is deemed to begin to run on Jan. 1 preceding the conversion date. In the example above, the five-year holding period for the R stock would be met on Jan. 1, 2021. Ignore the preceding warning for the converted item if the Roth IRA owner turns 59 1/2 during the five-year period.

A Roth IRA owner generally must pay the 10% additional tax on any amount attributable to the part of the amount converted that he or she had to include in income because...