Roth IRA conversions needn’t be all-or-nothing.
Dividing a conversion into multiple accounts, by type of investment, can minimize the current tax bill and maximize tax-free income. According to Leon LaBrecque, managing partner at LJPR, a financial advisory and wealth management firm in Troy, Mich., “segregated Roth conversions” facilitate flexibility in clients’ retirement planning,
Suppose Alice Smith converts $100,000 of her traditional IRA to a Roth in 2013. Any time until next October 15, Alice canrecharacterize (reverse) all or part of the conversion.
If that $100,000 Roth IRA grows to $110,000 Alice can leave the account alone, with $10,000 of gains she can access, tax-free, after five years and age 59-1/2.
On the other hand, if Alice’s Roth IRA sinks to $90,000, she can recharacterize the account back to a traditional IRA and avoid reporting $100,000 of taxable income in order to have a $90,000 Roth IRA.
However, what if Alice had invested that Roth IRA 50-50, stocks to bonds, and one asset class gained while the other lost? No matter whether Alice does a full, partial or no recharacterization at all, she’ll be paying some tax on assets that no longer exist or losing some potentially tax-free gains, or both. By converting to two $50,000 Roth IRAs, one to hold stocks and one for bonds, Alice has the ability to recharacterize the laggard, saving tax, while letting profits ride in the leading Roth IRA.
“In the vast majority of the Roth conversions we have done, we ‘vertically segregated’ the assets,” LaBrecque says. In some of those cases the assets were segregated by asset class; there might have been a large-cap Roth IRA, an emerging markets Roth IRA, and so on. The best performers could be retained as Roth IRAs while the others could go back to the traditional IRA. If an asset class had fallen in value, it could eventually be re-converted at a lower tax cost.
LaBrecque says that in some Roth IRA conversions the segregation was done so that each account held one fund or one security. “We chose the most volatile holdings that we felt had the most upside for conversion,” he says. Those included funds (often emerging markets or small-caps or micro-caps) as well as individual securities.
“Overall,” LaBrecque concludes, “we found the segregated conversions were useful and did optimize the tax aspects of the conversion. They were a lot of work, but we were able to aggregate the holdings into our profile management system, so we could track holdings. For the most part, client communications were effective, although we clearly spent a lot more time in meetings with our clients.” The drawbacks, he discovered, were having to consolidate many segregated Roth accounts after therecharacterization period and presenting clients with a great deal of paperwork.
“With the Roth IRAs we segregated by funds,” LaBrecque reports, “the results were beneficial, with no dramatic upside or downside results. With individual securities, the result have been considerably more dramatic. For example, we had a client with an issue of FNMA preferred. She converted at $0.83 in November 2009 and the stock is currently around $6.49, so we have a 682% tax-free gain. All in all, segregated Roth IRA conversions are an effective, but time-consuming strategy.”