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Roth IRA Conversions-An
Aggressive Strategy
by James
Lange, CPA, JD
August 2002
Uncertainty
and volatility in the market create both problems and opportunities
for IRA owners who desire to convert either a portion of, or their
entire IRA, to a Roth IRA.
We stand by
our conviction that many IRA owners would benefit from a Roth IRA
conversion assuming the income taxes on the conversion can be paid
with funds outside of the IRA. By implementing the aggressive
strategy outlined in this article, you may be able to “hedge your
bets” to take the full advantage of a Roth IRA conversion while
reducing the risk of a downturn in the market after making a Roth
IRA conversion.
This article
addresses the important question, “Which assets should the IRA owner
convert?” For more detailed discussions of the benefits of
a Roth IRA conversion and answers to the questions of how much and
when to make a Roth IRA conversion, I recommend the following articles:
IRAs After the TRA 97 – What Hath Congress
Roth? and The Roth's Real Advantage.1
The ability
to “unconvert” or reverse a Roth IRA conversion provides the key
to identifying which IRA assets you might opt to convert to a Roth
and the key to saving taxes. Technically, the correct
term is to “recharacterize” a Roth IRA back to a traditional IRA.2
First we need
to understand the regulations governing recharacterizations. Then
we will provide several examples of situations that can take advantage
of those regulations.
Rules Governing
Recharacterizations
As of 1998,
the IRS has permitted IRA owners to “unconvert” Roth IRAs.
The deadline for “unconverting” a year 2002 conversion is the
extended due date of your 2002 tax return, or October 15, 2003
assuming you can obtain two valid extensions.3
Normally you file your tax return by April 15, 2003. However,
if you file an automatic extension, you may extend the deadline
to recharacterize to August 15, 2003. If you are able to obtain
a second extension (which is not automatically granted), you will
receive an additional extension to recharacterize until October
15, 2003. We caution taxpayers that using the strategy in
this article may not be a sufficient reason for the IRS to grant
the second extension. (In effect in 2006 for the 2005 tax year and
for subsequent years, there is only one extension and it is good
through October 15. Therefore everyone should be entitled to this
extra hindsight period for “unconverting” Roth conversions).
There is also
a special rule that allows you to recharacterize a year 2001 Roth
IRA conversion as long as you filed your return timely and you take
corrective action within the six-month extended period.4
To take “corrective action” means following the steps required to
file the election to recharacterize the IRA.5 In
this case, the steps would include filing an amended return to reflect
the transfer.6 The transfer must occur before the
extended due date of the tax return for the taxable year in which
the original Roth conversion was made.7 After the
transfer back, the election to recharacterize the conversion cannot
be revoked. 8
There are also
rules limiting the frequency of conversions, recharacterizations,
and reconversions. You may not make a Roth conversion,
“unconvert” it and reconvert the same IRA money in the same year.9
Even if you straddle different calendar years, you must still wait
30 days before reconverting a Roth IRA that you had previously converted
and “unconverted.”10
Procedure
Notify the Trustees
(of both IRAs involved) on or before the transfer date that you
want to “unconvert” a particular Roth IRA. The notification
must contain the following information:
- the type
and amount of the conversion to the Roth IRA to be recharacterized;
- the
date on which the conversion was made and the tax year for which
it was made;
- a
direction to the trustee to transfer, in a trustee-to-trustee
transfer, the amount of the conversion and any net income allocable
to it to the trustee of the recipient IRA;and
- any
additional information needed to make the transfer.11
If both of your
IRAs are maintained by the same trustee, simply redesignating the
IRA will be treated as a trustee-to-trustee transfer.12
You must also report the recharacterization on the tax return for
the tax year in which you made the original Roth conversion.13
Profiting
from the Rules
How do we profit
from these rules or, looking at it another way, is there a legal
loophole that can save IRA owners money?
Example 1:
Roth IRA Conversion Made in the Year 2002
Assume that
Joe has five separate IRAs of $100,000 each, invested evenly in
five asset classes-large cap stocks, small cap stocks, bonds, international
stocks and cash. Any conversions or unconversions will be
made through separate accounts. Though there is uncertainty
as to the optimal amount to convert and when, let's assume Joe would
benefit from a $100,000 Roth conversion during 2002.
Joe's options
include:
- Action:
Make a $100,000 conversion now (mid-2002) of any one of the asset
classes and hope for an increase in the value of the investment
that he chooses to convert.
Result: It is a crapshoot. If he converts
$100,000 and the investment increases to $200,000 by October 15,
2002, he will have a $200,000 Roth IRA for the tax on $100,000
conversion. This is a great deal. If the investment
declines, it is not a great deal. If he converts an investment
that is valued at $100,000 and it drops to $50,000 by the following
October, he will be stuck paying income tax on $100,000 and only
having a $50,000 Roth IRA. If the investment goes down,
Joe should recharacterize the Roth IRA to avoid the tax
on a $100,000 conversion. If he “unconverts” his Roth,
he will be in a position similar to where he would have been if
he had never made the conversion. Assuming the traditional
IRA would also have declined in value had it been left alone,
Joe will have a $50,000 IRA (and his experimental foray into the
Roth environment will have had no tax consequences). Although
it is discouraging that the investment went down, it isn't as
bad as if he had had to pay income tax on a $100,000 conversion.
The only way this strategy is a winner is if Joe picks the right
asset class to convert.
- Action:
Make a $100,000 conversion now (mid-2002) consisting of one-fifth
of each of the five asset funds and hope for an increase in the
value of the investments.
Result: This strategy is an attempt to hedge.
This strategy will produce no windfall from investment returns,
but will be a safer bet by using diversification to spread the
money around. Joe may still “unconvert” the funds that break
even or lose money, although this will reduce the total conversion
amount and possibly not fulfill Joe's original objectives.
- Action:
Don't make any Roth IRA conversions.
Result: A “do-nothing” strategy misses any opportunity
to enjoy the tax-free growth offered by Roth IRA conversions.
Perhaps it would be advantageous to consider a Roth IRA conversion
in the future.
- Action:
Thread the loophole. Convert all five traditional IRAs to
Roth IRAs and be primed to “unconvert” the investments that do
the worst from the time of conversion to August 15, 2003 and if
a valid second extension is accepted, until October 15, 2003.
Result: With perfect hindsight, Joe “unconverts”
$400,000 of the original investments that did not perform as well
as the $100,000 that Joe can choose to retain as a Roth IRA.
Lucky Joe could reap an enormous windfall of tax-free growth in
any one of the asset classes.
He will still
have to pay income tax on the $100,000 income for tax year 2002
(for the asset class he chooses to retain as a Roth). However,
the value of the Roth will have increased. Then, possibly
within the same family of funds so there are no transaction fees,
he rebalances both his traditional IRA portfolio and his Roth IRA
portfolio. The result is that he now has a larger and well-diversified
Roth IRA.
If the portfolio
is comprised of individual securities, the same principle would
apply. (As required under new rules which went into effect subsequent
to the original publication date of this article, separate Roth
IRA accounts must be used to accomplish this objective for separate
classes of securities). You could retain as Roth IRAs the securities
that did well and recharacterize the ones that did not. However,
we recommend that securities not be traded after conversion so they
may be properly identified for purposes of unconversion, should
it become necessary. (This would no longer be necessary under the
new rules).
If the future
works out differently, Joe would respond differently. If all
the asset classes went down, Joe could consider recharacterizing
all of them in 2003 and then consider a future conversion based
on lower values.
Of course, most
clients will feel uncomfortable with the “thread the loophole” approach.
It may seem like too much of a gamble. There could be “follow
through” failures. The IRA owner might forget to “unconvert”
and that could present a financial disaster. Or the IRA owner
might die. (Though Roth IRAs are perhaps even more favorable
for estates than traditional IRAs because the executor, administrator,
or other person responsible for filing the final tax return for
the decedent may “unconvert” on behalf of the decedent.)14
What follows
is a potential timeline for the conversion and recharacterization
process.
Time Line
2002
Make
a conversion before year-end. Please note that many brokerage
houses need at least a week and sometimes longer to process the
paperwork. Therefore, I would consider the practical deadline
to be about December 15, 2002 to make the conversion.
2003
April 15
- File first extension for your 2002 tax return if you want more
time to decide on your year 2002 conversion. As noted above,
you can file your return if you are ready and still take advantage
of the six-month additional period to make the recharacterization,
but you must be prepared to affect the transfer and file an amended
return by October 15.
August
15 - Deadline to “unconvert” undesirable 2002 conversions and
file by the close of the “automatic” extension period. (Filing
a second extension is possible, with a valid reason and approval
from the IRS. It is not automatic. We would not
recommend that you request a second extension for reasons related
to “waiting to see how your converted Roth IRA investment performs,”
since this will probably not be viewed as a valid reason by the
IRS.)
September
15 - First opportunity to reconvert the recharacterized
traditional IRA. (Could be earlier if the recharacterization
was done earlier than the deadline.)
October
15 - Final deadline
to “unconvert” undesirable 2002 conversions with a valid second
extension or by means of an amended return.
November
16 - First opportunity to reconvert the recharacterized traditional
IRA. (Could be earlier if the recharacterization was done
earlier than the deadline.)
December
31 - Last chance for
additional Roth conversions for 2003.
This timeline
does not project beyond 2003, but barring other tax law changes,
the same logic would continue to apply for future years.
Conclusion
The most important
piece of advice in this article is: when in doubt, make the
conversion. You can always recharacterize or partially recharacterize
later if the conversion proves counterproductive. But if you
win with the Roth conversion, the long-term benefits of owning a
Roth IRA are superior to the traditional IRA.
Most clients
will not have the interest or the time to engage in some of the
more complicated strategies suggested in this article. But,
for clients or planners who do take the time to properly implement
the suggested strategy, the potential for rewards is great.
2
Code Sec. 408A(d)(6); Reg. § 1.408A-5.
6
See Instructions to IRS Form 8606.
7 Reg. §1.408A-5, Q&A-6(b).
9
Reg. §1.408A-5, Q&A-9 (a).
11
Reg. §1.408A-5, Q&A-6(a).
12
Reg. §1.408A-5, Q&A-1(a).
13
Reg. §1.408A-5, Q&A-6(b).
14
Reg. §1.408A-5, Q&A-6(c).
Reprinted
with Permission from the Journal of Retirement Planning.
The advice
in this article should only be undertaken with full understanding
of the risks and under the direction of a qualified advisor.
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