Long ago, there wasn't much that planners had to worry about as far as taxes except for lawmakers changing tax law. Now we have to worry that, if Congress does nothing, taxes will jump in 2013. In these financially tumultuous times, Roth conversion strategies can reduce risk substantially for clients in 2012.
UNKNOWNS FOR 2013
Regardless of whether Republicans or Democrats prevail in controlling the White House and/or Congress in November, there is likely to be an impact on tax law. If nothing is done, the Bush-era tax cuts will expire and the highest federal individual income tax rate will increase to 42%, taking into account deduction phaseout. On top of that, if the federal health care overhaul survives legal challenges, an additional 3.8% Medicare surcharge on investment income for those earning more than $200,000 ($250,000 for joint returns) will take effect.
As if the political uncertainty weren't enough, the wild swings in the stock market and other investments create further uncertainty. Will the euro survive? Might there be a major natural disaster? One way of planning for these uncertainties is to predict the outcome and prepare for it. Unfortunately, predictions of market strategists have proved to be very inaccurate. A much better way is to admit we don't know the future and plan as such, giving as much flexibility as possible to our clients. Enter the Roth conversion.
TRADITIONAL VS. ROTH
Gregg Polsky, a tax professor at the University of North Carolina School of Law, suggests we view a traditional IRA as a partnership between the taxpayer and the government. If the client has a $100,000 traditional IRA (with a zero basis if it was funded with pretax dollars) and is in the 35% marginal tax bracket, the taxpayer owns $65,000 while the government (federal and state) owns $35,000. The IRA is a partnership between the taxpayer and the government. Admittedly, the ultimate tax bracket upon withdrawing the funds from the traditional IRA is unknown.
Polsky notes that, if the taxpayer decides to convert this IRA to a Roth IRA, he or she is buying out the governments' ownership in the partnership and can then keep all of the returns tax-free going forward. At least this is true without a major change in the tax law. If the client does a Roth conversion in early 2012 with some or all of their traditional IRA funds, he or she has as late as Oct. 15, 2013 (if they file an extension on their 2012 return) to recharacterize some or all of the conversion.
Polsky refers to this recharacterization as a free put option. By exercising the put option, the taxpayer requires the government to buy back its original share of the IRA for the purchase price the taxpayer paid. I liken it to the undo key on a computer. It is this put option that can be so valuable in hedging political and market uncertainty.
John Bledsoe, author of The Gospel of Roth: The Good News About Roth IRA Conversions and How They Can Make You Money, recommends that everyone should convert 100% of his or her IRAs to Roth IRAs as early in the year as possible. Robert Keebler, a partner at Keebler & Associates, a tax and estate planning firm in Green Bay, Wis., agrees. Both specialize in assisting clients to carry out Roth conversion strategies.
They each note that a lot can happen between Jan. 1, 2012, and Oct. 15, 2013. If clients go into the conversion with the premise that they may recharacterize, they in essence get a free look and can keep any conversions that make sense. "Why wouldn't anyone want this free look?" Bledsoe asks.
Here are three strategies for hedging future uncertainties:
1. Simple hedging against 2013 tax increases and market declines. This is the simplest and most straightforward of the strategies. To protect against potential tax increases and even a market decline, the client can convert that $100,000 and pay $35,000 to the IRS. If it turns out that tax rates did increase, the client could save up to 10% by converting in 2012 instead of waiting.
If rates didn't increase, then a recharacterization may be in order. But Keebler believes a 2013 income tax increase is likely, although he sees the Medicare surcharge in the hands of the Supreme Court.
The second reason a client may want to recharacterize is if the market has a significant decline. Say the $100,000 portfolio declined to $80,000 sometime before 2012 taxes are filed in 2013. Rather than take the whole $20,000 loss, hit the undo button and recharacterize, and the government will take 35% of the loss. In this case, even if tax rates did decrease, the gain from the government taking on a share of the loss is larger than the hit from the tax increase. Both must be taken into account in the decision to recharacterize.
2. Multiple Roth conversions. Polsky, Bledsoe and Keebler recommend against doing a single Roth conversion. The strategy they recommend is to open separate accounts, such as accounts by asset classes. For example, you could have five Roth accounts in U.S. stocks, international stocks, REITs, precious metals and mining stocks, and bonds. If, for example, bonds and precious metals and mining decline significantly, exercise that put option and recharacterize. Keep the others that appreciated, knowing you bought out the government's share of the partnership at a lower price than the current market value.
There are no limits on the number of accounts one could convert. A client could have a thousand different securities and convert each one to a separate Roth IRA. That way, any security that declined could be recharacterized. Neither Bledsoe nor Keebler does this for his clients, noting the concept of diminishing returns, as well as planner expense from the additional work. Bledsoe and Keebler have each done 10 or more accounts for IRAs exceeding $10 million in value. They typically recommend about four to six separate conversions.
3. High volatility, negative correlation. Polsky wrote last year in the newsletter Tax Notes that the optimal strategy would be to convert two IRAs of equal value, investing in two highly volatile but negatively correlated securities, one in each account. If, for example, there was $50,000 in each at the start and one was wiped out while the other doubled to $100,000, the client has converted $100,000 into a Roth while paying taxes on only $50,000. This is because the client will recharacterize the IRA that went to zero, while maintaining the one that doubled.
The trick is to find securities that fit this bill, Polsky says, because IRAs cannot sell securities short or buy options. To overcome this barrier, perhaps an approach could be two inverse securities, such as the ProShares UltraPro S&P 500 ETF (UPRO) and the UltraPro Short S&P 500 ETF (SPXU) would work, since each levers three times.
Unfortunately, in a year like 2011 when the S&P 500 was relatively flat, and due to the specifics of these funds, which essentially invest in a one-day duration and have substantial fees and costs, both would have been in the red. The UPRO fund lost 11.8%, while the SPXU plunged 32.3%.
Polsky, Bledsoe and Keebler note that they have not performed this strategy. Polsky worries that the IRS could challenge it, although he says it would be difficult for the agency to act if a taxpayer could show he or she had used readily available investment options (as opposed to a customized derivative). Nonetheless, the cost of defending an IRS challenge could be substantial.
BARRIERS TO CONVERSIONS
If a free look into the future is so compelling, why aren't more people converting their IRAs? One answer may be behavioral economics. When clients convert, they must pay taxes, reducing the size of their portfolio. Economically, of course, the Roth money is far more valuable than the traditional IRA funds, and there has not been a decline in economic net worth.
Polsky asserts in the Tax Notes story that financial advisors may be another hurdle. Advisors who are paid by commissions or wrap fees no longer earn fees on the assets used to pay the taxes for the conversions.
One more reason clients hesitate to convert is that the move is not risk-free. Polsky notes it's possible Congress could change laws - even take the unlikely step of taxing some Roth distributions. Polsky likens it to the tax on Social Security benefits. A similar worry would be a revamping of the tax code, such as an enacting of a consumption tax to replace the current income tax. That would effectively result in paying the tax at conversion and again when goods and services are purchased.
There is nothing simple about taxes, but a Roth conversion with the recharacterization option offers a way to both reduce risk and lower taxes. Before moving forward, advisors need to be sure a client has paid enough estimated taxes to meet the safe harbor rule so that penalties and interest won't kick in if a client decides not to recharacterize.
It's best to maximize the value of the put option by doing the conversion early in the year and following the timeline in the "Roth Conversion Timeline" chart, above. Also make sure a tax expert is guiding your client.
While there is a lot of uncertainty between now and Oct. 15, 2013, there is far more uncertainty decades later when clients may be spending down their IRA money. No one knows what tax rates will be 20 years from now or a client's net income.
There's also the possibility of a radical tax change like a consumption tax. That's why many experts do not recommend keeping 100% of IRA funds in a Roth. Instead, a better strategy would be diversifying against those unknowns by having some taxable traditional IRA funds and some Roth IRA funds. Nonetheless, there is a way to help your clients increase their Roth IRA funds while minimizing taxes.
Allan Roth, founder of the planning firm Wealth Logic in Colorado Springs, Colo., writes the Irrational Investor column for CBS MoneyWatch.com and is an adjunct faculty member at Colorado College and the University of Denver.