This question, or a variation of it, has become very commonplace due to the current stock market. While the simple answer is that the law states that it is too late to recharacterize a 1998 (or 1999) Roth conversion, it is possible that the IRS will still permit a late recharacterization based upon these circumstances. The request to the IRS has to be in the form of a formal ruling request and while there is no guarantee that the IRS will issue a favorable ruling, it could be worth the expense of trying. Alternatively, there may be a way to at least partially salvage the situation. Whether it pays to do so will have to be evaluated on a case-by-case basis, since everyone's numbers are different.

A Roth IRA is created with after-tax dollars. Therefore an individual has a basis in her Roth IRA. The IRS rules states that if an IRA with basis is terminated and the value is less than basis, that difference can be taken as a miscellaneous itemized deduction, subject to the 2% of adjusted gross income limitation. So if a Roth that was converted at $100,000 is now worth only $20,000, terminating the account will cause an $80,000 itemized deduction. But there are other factors that come into play, so a complete analysis is required.

First of all, the requirement that the IRA be terminated means that all accounts of the same type, traditional or Roth, must be emptied for the IRA to be terminated. If you have a conversion Roth and a contributory Roth, you cannot get a deduction by emptying the conversion account while you keep the contributory account. All Roths will have to be emptied.

Let's assume the taxpayer in our example only has the conversion Roth, and wishes to terminate the account to take the deduction for year 2001. She now withdraws the $20,000 of assets and terminates the account. The 2001 income tax return will be affected as follows:

-The $25,000 of conversion income (25% of the original $100,000) must still be reported on the 2001 income tax return.

-Unless an exception applies, the $20,000 withdrawal will trigger a 10% early withdrawal tax in the amount of $2,000.

-The termination of the Roth IRA will cause an itemized deduction of $80,000. This deduction is reduced by the 2% of AGI limitation. However it may cause the imposition of the Alternative Minimum Tax which will further limit the usefulness of the deduction.

The above adjustments could well cause the 2001 income tax to be higher because of the 10% early withdrawal tax and the Alternative Minimum Tax. In addition, the Roth IRA will no longer be in existence.

If the Roth IRA has suffered a severe decline in value, the tax savings from terminating the Roth will be minimal unless the current year's income is high enough to make the deduction worthwhile. Otherwise, either try to get IRS permission to do a recharacterization, or just try to get the Roth to recoup the loss.  Try the Will Rogers method - only invest in stocks that go up.