As my MFA Partner Jim Guarino mentioned in a November 2009 blog post on Roth IRA conversions, starting this year all taxpayers — regardless of income levels — can now convert a traditional IRA to a Roth IRA. This change applies to 2010 and beyond but carries a special tax incentive for 2010 conversions; the income tax due on the 2010 conversion can be spread equally over the following two tax years (2011 and 2012).

I’d like to follow on Jim’s blog post and offer some additional food for thought on the subject of Roth IRA conversions. In particular, I’d like to share a little known Roth conversion strategy that is worthy of consideration. In essence, it’s a strategy that involves converting a traditional IRA to multiple Roth IRAs, each with a single, distinct asset class. By implementing this type of strategy, investors allow themselves the time and the opportunity to assess the performance of each Roth IRA separately before committing to making the conversion permanent.

Under current Roth IRA conversion rules, investors can “undo” conversions any time before the tax filing deadline for the conversion year. This is what’s known as a “Roth recharacterization.” Understand though, that recharacterization is an “all or nothing” decision. The IRA owner cannot “cherry pick” and recharacterize only those Roth IRA assets that declined in value. If one elects to recharacterize, the entire Roth IRA must be recharacterized, hence the reason for creating a number of Roth IRAs, each with a single, distinct asset class.

Putting a Roth Segregation Strategy Into Play

To put a Roth segregation strategy into play, investors simply convert the portion of the traditional IRA they wish to convert into multiple Roth IRAs, each of which holds a different asset class (bonds, U.S. equities, international equities, real assets, private equity, etc.). The idea behind this allocation strategy is to isolate (or segregate) the returns from each asset class, as they will likely all perform differently, and then keep the best performers as Roth IRAs and recharacterize the losers back to traditional IRAs. It doesn’t change the fact that certain investments lost money, but at least no taxes are due on the Roths that declined in value. Investors will only owe taxes on the Roth IRAs left converted and will have eliminated paying taxes on the Roth amounts that were recharacterized.

To illustrate, let’s consider the following scenario.

Barbara has a single, $100,000 traditional IRA. She would like to convert the entire $100,000 into four Roth IRAs, each invested in a different asset class. In order to do so, she splits her $100,000 into four separate IRAs based on these distinct asset classes. She then converts those four IRAs into four separate Roth IRAs. Once that’s done, it’s time to sit back and watch how they perform.

Prior to April 15^th of the following year (or October 15^th if an extension is filed), Barbara will assess which Roth IRAs performed well and which declined in value. Let’s say two declined substantially. Barbara can “undo” those two Roth IRAs by recharacterizing them back to traditional IRAs. By doing so, Barbara will not have to pay taxes on the total $100,000 she initially converted; instead, she will only pay taxes on the two remaining Roth IRAs.

Now, the story doesn’t end there. Barbara can take advantage of the decline in value to once again convert those recharacterized IRAs back to Roth IRAs, but now at lower values and thus lower taxes. The only stipulation is that she wait 30 days after the recharacterization or one year after the initial conversion, whichever is later. By continuing to use this segregated conversion approach, Barbara has in effect adopted a strategy that minimizes conversion taxes within the larger goal of ultimately converting her traditional IRA to Roths.

This strategy combined with the ability to recharacterize may be beneficial in other areas. For example, anticipated tax law changes, changes in one’s financial situation or other planning considerations may prompt an IRA owner to consider recharacterizing a portion of their Roth IRA before the deadline. An all-or-nothing recharacterization scenario can leave one handcuffed, whereas the flexibility and hindsight offered by this strategy could prove to be invaluable. The new Roths don’t have to be segregated by asset class, either. One holding private equity in an IRA might hedge their conversion approach by segregating unit holdings into multiple IRAs, and then monitoring valuation changes near the tax filing deadline. Beyond the tax benefits is the ability to far more easily benchmark the performance of your various investment holdings within IRAs — tough to do in the all too common “pooled” IRA approach.

Although this strategy is straightforward, it does require the insight of a financial planner with extensive tax experience to ensure conversion taxes are minimized without impeding on the overall conversion strategy and financial plan.  Be sure to contact a skilled practitioner for guidance.

This entry was posted on Tuesday, February 16th, 2010 at 5:06 pm and is filed under Wealth management. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.