Roth IRA conversions have the potential to create considerable value for people who have enough funds available outside of their retirement accounts to cover the taxes they generate. Roth conversions benefit from not being subject to the 2016 contribution limit of $5,500 per year (or $6,500, if you're age 50 or older) or any income limitations.
Does a conversion make sense for you?
The debate regarding paying tax now by converting pre-tax accounts or deferring tax to future years usually involves attempting to predict how your tax rates today will compare to the future. This is no easy task for anyone, but there are a number of circumstances in which converting is very likely to be the right choice. A temporary decrease in income could provide the opportunity to take advantage of lower tax rates. For example, younger retirees under the age of 70½ (before they are required to take required minimum distributions) may have lower income than during their working years.
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If you're unsure whether converting makes sense for the current tax year, there is also a lesser-known technique that has the potential to further increase the value of Roth IRA conversions.
You have until mid October in the year after the Roth IRA conversion to undo part or all of it, a process known as recharacterization. (For example, for a conversion made in 2015, you have until October 17, 2016, to undo it.)
Why would you want to undo a Roth IRA conversion?
The greatest benefit of undoing a Roth conversion occurs when the value of the investments in a recently converted account has decreased since conversion. For instance, if you converted $100,000, and a year later, the account value drops to $70,000, you have created $100,000 of taxable income and only have $70,000 to show for it. Fortunately, you can fix the negative tax consequence by undoing the conversion and avoiding paying tax on the full $100,000. You are given the option to undo a conversion until your tax return is due (including extensions) for the year the conversion took place. In theory, you could convert a pre-tax IRA in the beginning of January and undo the conversion up until October 15th of the following year.
After recharacterization, as long as it is not the same calendar year as the original conversion, you can once again convert the same account back to a Roth IRA after a 30-day waiting period. This could allow the same assets to be converted with a smaller tax burden than the original conversion.
How to Invest for a Roth IRA Conversion
It may be possible to increase the value of a Roth IRA conversion even further with strategic investment selection. The expected value of undoing a conversion increases as the volatility of investments in a recently converted account increases. Therefore, you can increase the value of a conversion by placing more volatile asset classes, such as stocks, in a recently converted Roth IRA and leaving investments that are more likely to be stable in other accounts. For example, an investment in high-quality, short-term bonds would be unlikely to provide the opportunity to take advantage of the option to undo a conversion. On the other hand, an emerging-markets fund is considerably more likely to provide an opportunity.
It is important not to lose sight of your objectives and risk tolerance if you plan to have different allocations in different accounts. If, for example, you have a target allocation for your portfolio of 60% stocks and 40% bonds, you would want to make sure your investment portfolio as a whole is allocated the way you originally intended. You could accomplish this by holding more than 40% bonds in an account that was not recently converted to compensate for more aggressive holdings in the recently converted account. In other words, when you look at all of your accounts on a combined basis, the total allocation would be the same—60% stocks and 40% bonds—regardless of how individual accounts are allocated.
Executing this strategy properly typically involves creating a separate Roth account for each conversion, notifying the trustees of your retirement accounts with regards to conversion and recharacterization and properly completing the necessary tax forms. (I highly recommend you consult a tax professional before implementing a strategy like this, as tax laws may change and mistakes could end up being costly.)
Kevin Peacock is the founding partner of Astra Capital Management based in New York City. His firm specializes in investment management that integrates alternative investments with traditional asset allocation.
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