First Person: The Right Way to Convert a Roth IRA

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The odds are good that effective tax rates will be higher in the future and that now is a great time to convert part of a traditional IRA into a Roth IRA. I have been advising my clients that they should consider the conversion of at least part of their portfolio. This may save them money on future taxes and will lower their Required Minimum Distributions. The RMD only adds to your taxable income and going forward may make you subject to a 3.8 percent surcharge on investment income. Money taken from a Roth IRA will be tax free and not appear on your tax return.

One concern that I have, as should anyone doing a Roth conversion, is paying taxes now and watching the value of the account decline. Fortunately, the IRS will allow you to declare a mulligan and undo the conversion. We call this process a recharacterization. You have until October 15th of the year following the year in which you did the conversion to do the recharacterization. You are allowed to declare a full mulligan or recharacterize just a portion of the amount you converted. However, you are not allowed to cherry pick investments within the account. This means that if you converted $50,000 and invested equal amounts in stock A which doubled, and stock B which became worthless, any recharacterization would involve taking back the loss as well as the gain. Even if you recharacterize just a portion of the conversion, you would still be paying tax on part of the loss and losing the tax free nature on part of the gain.

My solution will allow me to maximize my tax benefit. I will open a separate Roth IRA for each of the asset classes which I will be using. Each asset class has separate risk/reward characteristics. BlackRock Solutions provides a nice chart showing the annual returns and standard deviation of a number of asset classes and help illustrate why I use multiple accounts. Over the past 20 years (1992-2011), large cap value stocks have an annual return of 8.9 percent, international stocks 4.6 percent, bonds 6.5 percent, small cap stocks 8.5 percent and large cap growth stocks 6.6 percent. If I open up separate accounts with $10,000 in each asset class, I will be able to isolate the tax advantages if I decide to declare a mulligan. For arguments sake, let us assume that during the holding period, small cap stocks rose 35 percent, bonds returned 6 percent and international stocks gained 12 percent, while large cap value stocks declined 30 percent and large cap growth dropped 10 percent. The account value would be $51,300, but contains $20,000 of investments which lost $4,000, on which I already paid taxes. What I would do here is simply recharacterize the two accounts that lost and file an amended return declaring a conversion of only $30,000. I will skip paying taxes on the loss and receive the complete benefit of the tax-free appreciation in the three remaining accounts. I can later roll the accounts into one and keep open the five accounts for future conversions.

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