A strategy for splitting investments into separate Roth conversions gives advisors a way to take advantage of 20/20 hindsight.
Roths have gained in popularity since 2010, when the income limits on Roth conversions were lifted. As a result, the ability to recharacterize or undo a conversion is increasingly being used proactively. To take advantage, advisors help clients convert traditional IRAs into Roth IRAs, then wait to see what happens with the investment. If its up, the conversion stays and if its down, the account gets recharacterized, available for a future conversion (at a lower tax cost).
The real opportunity here is to complete the conversion one investment or asset class at a time, creating a series of stand-alone Roth IRAs. This gives clients up to a 21-month time window to see the results: They can then decide to keep the top performers and recharacterize the rest.
When Roth IRAs were originally established, taxpayers could have no more than $100,000 in adjusted gross income in order to convert, limiting the opportunity for many clients. Since the beginning of 2010, though, anyone has been permitted to complete a Roth conversion, regardless of income.
When a conversion occurs, taxes are paid on the original IRA, but no early withdrawal penalty applies as long as the funds in the conversion are held for at least five years.
In the early years, taxpayers sometimes needed to undo a Roth conversion because they were over the income limits by the end of the year. And even with the income limits gone, taxpayers may sometimes wish to undo a Roth conversion if a jump in income results in a higher tax rate than expected.
Another reason to undo a Roth conversion is if the investment falls significantly in value after the conversion, and the taxpayer would like a chance to convert it again at a lower value.
Fortunately, the rules allowing the client to reverse course via a Roth recharacterization are relatively straightforward. The deadline to recharacterize is Oct. 15 of the following year (even if an extension has not been filed), and the converted funds (along with any associated gains or losses) simply have to be transferred from the Roth back to a traditional IRA.
Once the recharacterization is complete, its as though the conversion never happened, and there are no income tax consequences at all. Further, after a recharacterization happens, clients can do a new conversion. They just need to wait until either 30 days after the recharacterization or the year after the conversion year, whichever is later.
By way of example, lets say your client completes a Roth conversion in February and decided to recharacterize in November of the same year, when he realizes his income is going to be so high that it wont be desirable to keep the conversion. As a result, he recharacterizes his conversion; he will not be permitted to do another conversion again until the following year.
But if he waits until April 10 of the next year, as he is finishing his tax return, to recharacterize, he can do another Roth conversion as soon as May 10 just 30 days later.
GAINS AND LOSSES
When an entire traditional IRA is converted into a Roth account and subsequently recharacterized, the process is relatively simple: The entire Roth IRA is transferred back to a traditional IRA, since it will already include any gains or losses that occurred during the temporary conversion period.
But when the original conversion becomes only a portion of an account if, for example, the conversion is added to an existing Roth account Treasury regulations stipulate that the recharacterization must include a pro rata share of the gains or losses of the entire account.
Lets take another example. Say your client converts $50,000 of XYZ stock from her traditional IRA, adding it to an existing $200,000 Roth IRA account thats invested in a broad range of assets; the total is now $250,000. Early the next year, she realizes that the XYZ stock has declined 30%, to $35,000, while the rest of the account is up 20% (to $240,000). She would like to recharacterize the XYZ stock conversion, since it triggered income tax consequences on $50,000 but is now worth only $35,000.
In this case, she cannot recharacterize just the stock: Instead, she must recharacterize a pro rata share of the entire account. So, she must recharacterize $55,000 since the total account balance started at $250,000 and is now $275,000, in the aggregate it is up 10%. This means she has to put back all of the XYZ stock and another $20,000 of investments that were in the Roth IRA in the first place a disadvantageous move.
Fortunately, there is a way to avoid the unfavorable result. Under Treasury regulations, the pro rata recharacterization rule applies only to the actual IRA containing the particular contribution to be recharacterized. So if a Roth conversion occurs to a stand-alone account, only that account and the associated gains or losses must be considered when completing a recharacterization.
Continuing the previous example, if your client converts the $50,000 of her XYZ stock to a stand-alone second Roth IRA (instead of mixing it with the first Roth IRA) and it then declines, she would need to recharacterize only $35,000 the actual value of the entire second Roth IRA containing XYZ stock. This would allow her to enjoy the benefits of recharacterization (avoiding $50,000 of conversion income on stock now worth only $35,000) without being forced to shift additional Roth IRA assets back to a traditional IRA.
Given how much more favorable it is to recharacterize a particular investment that has gone down in value after a Roth conversion, it is now a standard best practice to do new conversions to a stand-alone Roth IRA whenever there is a chance of a material decline that would trigger a desire to recharacterize which is to say, just about any time the assets involved include equities, commodities or any other relatively volatile asset class.
At worst, the second Roth IRA can always be merged with the first for simplicity after the recharacterization window has passed and its certain the account will remain in place.
The rules also allow for a more proactive Roth conversion strategy involving larger conversions that include multiple investments or whole asset classes.
See the Using Multiple Accounts chart on the below for an example. Lets say your clients plan to convert $300,000 worth of various investments in their traditional IRA, which consists equally of real estate, commodities and equities.
Rather than transfer the $300,000 into an existing Roth IRA or even into a stand-alone $300,000 Roth, they can instead create three new $100,000 Roth IRAs: one for the real estate, the second for the commodities and the last for the equities.
If they complete these conversions in January, they can wait up to 21 months (until early October of next year) to decide whether to recharacterize any of them.
Lets say that, after the time interval, the equities are up 15%, the real estate is up 5% and the commodities are down 10%. Your clients can cherry pick the winners to keep the converted equities and real estate in place but recharacterize the commodities allocation, which is now worth only $90,000.
One important caveat of this strategy: If they want to try again to convert the commodities that were recharacterized, they must wait 30 days and at that point would have at best only 11 months (from November of this year until Oct. 15 of next year) to try again.
In addition, say the conversion was made last year because it was a year of low income in which one spouse lost his job, but he is now employed again with higher income. In that case, it might be preferable to keep investments that are down only slightly as a conversion, because it would be even less favorable to try to convert again at the clients now-higher tax rate.
In theory, the multiple-account Roth conversion strategy can be relevant for any asset and account size. But from a practical perspective, investors may not want to split accounts until the dollars are significant say, tens of thousands of dollars, if not hundreds of thousands.
Given the relative simplicity, however, anyone doing a Roth conversion should keep the funds separate from any existing Roth IRA funds unless there is no material chance of a decline if, for example, the assets are held in cash or short-term bonds, for some reason.
For those who wish to split a conversion itself into multiple accounts, its obviously crucial that the funds be invested differently in the first place. If there are different investments, they should be substantively different, with a low expected correlation. Otherwise, their returns may be so similar that having separate accounts will be irrelevant.
Its crucial to remember that the core driver of whether a Roth conversion will be effective is a comparison of current and future tax rates. Subsequent growth determines how much wealth is created by a good Roth conversion, but doesnt determine whether it will be favorable in the first place.
As a result, even with favorable growth, an investor should keep only a Roth conversion thats done at a favorable tax rate. If so much is converted that it drives the tax rate too high now, greater growth will actually make the outcome worse.
Michael Kitces, CFP, is a partner and director of research at Pinnacle Advisory Group in Columbia, Md., and publisher of the planning industry blog Nerds Eye View. Follow him on Twitter at @michaelkitces.
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