Roth IRA conversions should be discussed with most investors this year as part of their overall retirement planning strategy. Odds are, many clients will be unsure about whether a Roth conversion is suitable for them. If so, they should be reminded of their ability for a “do-over” by re-characterizing the account as a traditional individual retirement account, if that seems prudent from a tax planning perspective.
The unique opportunity for a do-over is particularly advantageous if underlying investments are managed appropriately.
The best way to prepare for a possible re-characterization is to use an asset allocation approach, dividing existing IRA assets among multiple Roth IRAs. The benefits can be significant, particularly given today's uncertain market environment.
When dollars in an IRA are transferred to multiple Roth IRAs categorized either by investment or by asset class, investors gain significant value from the option to
re-characterize the Roth conversion based on the performance of specific investments.
Here is one way to look at it — an IRA is essentially a “box” into which investments are placed. An IRA with three different investments is still considered one box as far as the IRS is concerned.
If assets in a traditional IRA are converted to a single Roth IRA, that is considered one box, too. If a re-characterization were to occur, the money would come out of the single box, not specific investments within that box.
For example, if Tom owned a traditional IRA valued at $100,000 on March 1 (in this case, we'll assume it consisted exclusively of pretax contributions and earnings) and he converted the IRA on that date, he would owe tax on the $100,000 value. The tax liability would be $35,000 if he was in the highest income tax bracket.
Let's assume the market declines and that at the end of the year the value of Tom's IRA has dropped to $85,000. Since he converted to a Roth in March, he still owes $35,000 in taxes (the equivalent of a 41% tax rate on the year-end account value). As a result, Tom decides to re-characterize his Roth IRA, converting it into a traditional IRA.
Had Tom converted the entire $100,000 IRA to a single Roth IRA, he would not be able to pick specific investments (notably, the ones that lost value) to re-characterize.
A better choice would have been to convert the portfolio into multiple Roth IRAs based, for example, on asset classes. For the sake of simplicity, let's assume Tom had 60% of his $100,000 portfolio in large-cap stocks and 40% in high-grade bonds. Let's assume, too, that at the time of conversion, Tom established two Roth IRAs — one for stocks and one for bonds. If his equity Roth IRA loses 25% of its value and his fixed-income Roth IRA stays flat over the course of the year, Tom can choose to re-characterize only the IRA containing his stock holdings.
A further benefit is that re-characterization is not a one-way street. If Tom re-characterizes his stock IRA, he can convert those assets back to a Roth IRA 30 days later — as long as the round-trip conversions don't take place in the same calendar year. In Tom's case, the tax liability on the conversion would be reduced because the account is now worth less than when he originally converted it.
The asset class approach in converting to multiple Roth IRA accounts also can be effective as a tax management strategy. Assume that Tom's $100,000 IRA is split 50-50 between stocks and bonds, and that he converts both asset classes to separate Roth IRAs. The total tax (at the 35% tax rate) is $35,000, but by tax time, Tom realizes that since he has only enough cash to pay half the tax bill, he decides to re-characterize a portion of the converted amount.
In the case that the stock portfolio gained 20% (rising to $60,000), while the bond portion rose 5% (to $52,500), Tom could decide to retain the equity Roth IRA. As a result, he would pay just $17,500 in tax, which translates into an effective tax rate of 29% on the year-end value of $60,000. He would maintain the accumulated benefit of the conversion in the equity asset class, while re-characterizing the Roth IRA containing the lesser-performing asset class, the bond portfolio. Again, had he converted the entire $100,000 to a single Roth IRA, the opportunity to separate his investments for purposes of re-characterization would have been lost.
To execute these strategies, of course, investors and their advisers must work with an IRA custodian that allows individuals to open multiple Roth IRAs.
Craig Brimhall is vice president of retirement wealth strategies at Ameriprise Financial Inc.
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