Monday, February 8, 2010

Roth Conversion Strategies

2010 is The Year of the Roth. This has been a constant theme of mine in this blog as I attempt to highlight the opportunity and point out some of its dangers and pitfalls.

As with most strategies there is an "offensive" way to play it as well as a "defensive" way. The following article is definitely an offensive-minded strategy, involving account-splitting and characterization reversals. I hadn't thought of this. Here's what was written:


U.S. investors who convert a traditional Individual Retirement Account into two or more Roth accounts to make a bet on the market rising can save on taxes if it doesn’t.

The multiple Roth IRAs should be split among different investments, according to Joseph Spada, managing director of Summit Financial Resources in Parsippany, New Jersey, whose average client has $25 million in net worth. A conversion can be reversed if some of the assets lose value, saving $140,000 in income taxes, for example, on an account worth $1.2 million.

“The IRS is giving you a bucket of mulligans with your IRA,” said John Bledsoe, a Dallas-based estate planner, referring to the term used in golf for a do-over. Investors who convert to a Roth IRA have until Oct. 17, 2011, to undo their decisions and recoup taxes paid, said Bledsoe, author of “The Gospel of Roth,” whose average client has $100 million or more in assets.

The Internal Revenue Service lifted income restrictions this year on converting a traditional IRA to a Roth IRA, meaning U.S. taxpayers making more than $100,000 a year in adjusted income can make the transfer. There’s no limit on conversions if an investor has multiple IRAs or a cap on the amount that can be converted.

Those who switch from a traditional IRA, where taxes are paid only on withdrawals, to a Roth IRA, must pay income taxes upfront in exchange for tax-free withdrawals during retirement. A taxpayer in the top income bracket with an IRA worth $1.2 million would pay 35 percent or $420,000 in federal taxes when converting the account into a Roth IRA this year.

Three-Way Divide

A $1.2 million account could be divided into three Roth IRAs worth $400,000 each, Spada said. The first account may be invested in fixed income, the second in equities and the third in high-yield bonds. If one fund lost value, the investor would save the 35 percent tax paid on the $400,000 account, or $140,000, by recharacterizing that Roth IRA into a traditional one, Spada said.

“You don’t want to pay the tax on an account that actually went down in value,” Spada said. Undoing the conversion doesn’t change the fact you lost money on your investments, which is why investors shouldn’t take more risk than they normally would when converting to multiple Roth IRAs, he said.

Free Look

Theodore Lustig converted his family’s IRA into three Roth accounts with different asset types on Jan. 4. The 55-year-old attorney put the first account in fixed income, the second in oil stocks and the third in U.S. bank stocks.

“You have a free look,” said Lustig, who’s based in Dallas. “You have until October 2011 to see how your investments have performed.”

Lustig said he could reverse the conversion on accounts that decline or, “if everything works out,” pay a lower tax on income from accounts converted in January that rise in value.

“Even if it turns out that I will save taxes by converting, the conversion may still be undone if I just get cold feet or have unforeseen expenses and no longer want to pay the taxes on the income,” he said.



Wow. Combine a complicated law with a monetary incentive and all sorts of things can happen. Sort of like derivatives. Or securitization.

I don't have an opinion on these strategies. They purport to give a free lunch, something I don't believe exists in this world. I guess I would want to have a LONG conversation about them before I even considered them. As every tax attorney can tell you, "recharacterization"-- when used by the IRS-- is painful. So can be updated guidance, revenue rulings and tax cases. As with everything on this blog, do your own due diligence.

No comments:

Post a Comment