Roth IRA loss and mandatory 10% penalty

[Guest avalancheone]

In 2004, I have recharacterized my traditional IRA into Roth and at the year-end I got a 1099-R showing the total amount as taxable distribution. Unfortunately, I lost all the money in this Roth IRA through some bad investments. I still have my account open and this is the only Roth account. My understanding is that I can claim the Roth IRA loss under misc itemized deduction subject to the 2% floor, but I need to close my Roth IRA account. In 2004 I do not have any other income other than this distribution which I completely lost, so I was thinking I should NOT be paying any taxes (I have some other capital losses which offsets more than the 2% floor I cannot deduct, thus making my taxable income zero). However, if I close the account, this will be considered an early withdrawal of the original traditional IRA and I need to pay a mandatory 10% penalty. Is my understanding correct and is there a better solution?

[Appleby]

avalancheone, do you mean& convert instead of recharacterize?

If you converted your traditional IRA to your Roth IRA, you must include in your income any taxable amount of the conversion, whether or not you had losses on the investments.

See Recognizing Losses on Investments at http://www.irs.gov/publications/p590/index.html (Under Roth IRA) for information of claiming losses on Roth IRA investments

By the way, if you did convert your traditional IRA to your Roth IRA in 2004, you may reverse the conversion VIA recharacterization by October 15,2005, which would make the conversion null and void and therefore nontaxable.