Generally speaking, advisors want to reduce the risk in clients’ portfolios.
When it comes to a Roth conversion, however, risk can be a good thing, when combined with the possibility of recharacterizing (undoing) a conversion later.
We explain to our clients that traditional IRA assets are really a partnership between themselves and the government. If the client will be in the 30% marginal tax rate in retirement, a $100,000 IRA (with all pretax funding) would be 70% owned by the client. If the client converts $10,000 into a Roth, she will owe $3,000 in taxes and will now own 100% of that Roth IRA, having bought out the government’s share.
I often recommend that a client does several Roth conversions annually. Say this client does three $10,000 Roth conversions into three different risky asset classes: U.S. stocks, REITs, and precious metals and mining stocks. If the client had done this in early 2013 using low-cost Vanguard funds, as of April 23, 2014, she would have gained 32.7% in U.S. stocks, gained 13.5% in REITs and lost 32.1% in the Vanguard Precious Metals and Mining Fund.
The client bought the government’s share out at a great price for U.S. stocks and, in hindsight, a very high price for the precious metals and mining fund. But now the client can hit that undo button and recharacterize, getting back the $3,000 in taxes, which forces the government to buy back its share at the original $3,000 price. This can be done any time before the client files her tax return, which with an extension means as late as Oct. 15.
Placing the riskiest assets in the Roth conversion maximizes the value of the put, which can be used to make the government buy back that asset at the original price. This doesn’t mean one should take a poor risk or buy an asset with a zero or negative expected return. It does, however, show risk can be a good thing, as recharacterization gives the client 100% of the upside but, in this example, only 70% of the downside.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for CBS MoneyWatch.com and has taught investing at three universities.