A Powerful Secret to Increase the Value of Your Roth Conversion
If your recently converted Roth loses value, you can undo the conversion to save money on taxes.
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.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
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.
To continue reading this article
please register for free
This is different from signing in to your print subscription
Why am I seeing this? Find out more here
Kevin Peacock is the managing member of Astra Capital Management, a fee-only investment advisory firm based in New York City. Astra Capital Management utilizes an evidenced-based approach to investment management and financial planning customized for each client's unique wealth objectives. Kevin is a CFP® professional and holds the CAIA® designation. His educational background includes a master's degree in Financial Engineering and an MBA with a finance concentration.
-
Is a Phased Retirement Right for You?
Want to keep working, just not as hard? A phased retirement may just be the answer.
By Kimberly Lankford Published
-
Four Tips to Make Your Sales Presentation a Winner
Being prepared and not being boring can go a long way toward persuading a potential customer to buy into what you’re offering.
By H. Dennis Beaver, Esq. Published
-
Pros and Cons of Waiting Until 70 to Claim Social Security
Waiting until 70 to file for Social Security benefits comes with a higher check, but there could be financial consequences to consider for you and your family.
By Patrick M. Simasko, J.D. Published
-
How to Stop Boredom From Ruining Your Happy Retirement
Retirees who explore new interests and have an active social life are more likely to find joy — and even greatness — in the newfound freedom of retirement.
By Richard P. Himmer, PhD Published
-
The Life-or-Death Answers We Owe Our Loved Ones
How our life ends isn’t always up to us, but that question too often must be answered by loved ones and health care workers who don’t know what we would want.
By Joel Theisen, RN Published
-
Is 100 the New 70?
Eating well, exercising, getting plenty of sleep and managing chronic stress can help make you a SuperAger. Funding that long life requires longevity literacy.
By Phil Wright, Certified Fund Specialist Published
-
Nine Lessons to Be Learned From the Hilton Family Trust Contest
Disclaimers, good communication, post-marital agreements and more could help avoid conflict in a family after the owners of a wealthy estate pass away.
By John M. Goralka Published
-
Strategies to Optimize Your Social Security Benefits
To maximize what you can collect, it’s crucial to know when you can file, how delaying filing affects your checks and the income limit if you’re still working.
By Jason “JB” Beckett Published
-
Don’t Forget to Update Beneficiaries After a Gray Divorce
Some states automatically revoke a former spouse as a beneficiary on some accounts. Waivers can be used, too. Best not to leave it up to your state, though.
By Andrew Hatherley, CDFA®, CRPC® Published
-
What’s the Difference Between a CPA and a Tax Planner?
CPAs do the important number crunching for tax preparation and filing, but tax planners look at the big picture and come up with tax-saving strategies.
By Joe F. Schmitz Jr., CFP®, ChFC® Published