Heads You Win, Tails You Don't Lose

Here's how you win if your investment after conversion to a Roth IRA goes up, yet don't take a loss if it goes down. Say you have a $250,000 IRA account, but you only want to pay taxes on the conversion of $50,000 (say these taxes are $20,000 based on your combined federal and state tax rates). On January 2nd 2010, convert all $250,000 into five separate Roth accounts of $50,000 each. Invest each $50,000 in a different type of investment. Pay the $20,000 in taxes on April 15th 2011, but request an automatic filing extension to October 15th. Around October 1st 2011, see which of the Roth accounts has grown the most. Now transfer back the other four accounts from Roths to traditional IRAs (must be done by October 15th). You didn't pay any tax on the $200,000 which ends up where it bagan - in a traditional IRA account.

If all five Roths make a loss, then they all get 'recharacterized' back to traditional IRAs and you get a refund on the taxes you paid. You then have to wait 31 days before you can try again with the conversion back into a Roth. If the value is still down, this time there will be a lower tax bill.

Here are some other possibilities I see concerning Roths:

a) If you are holding investments that have gone down in value, but you are confident they will come back, convert before they go back up. The tax due will be calculated on the lower current value. For example, you have a rental house that is giving you the same monthly income, but has fallen to half its 2007 value. Converting now will mean any recovery in value will be tax free.

b) If you converted to a Roth in 2008 and your investments are down from that original amount, you have until October 15th 2009 to 'recharacterize' them back to a traditional IRA and reclaim the tax money you paid.

c) If you have a net worth large enough to pay estate taxes, using some of the money to pay the tax on conversion reduces the taxable estate. A smaller estate will save on estate taxes which are levied at a rate of 46%.

Here are some points to think about regarding the conversion process:

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a) If you have a mix in your regular IRA of pre-tax and after-tax money, you can't just transfer the after-tax amount - the IRS will say the transferred amount contains the same proportions of pre-tax and after-tax contributions as the whole account, plus any other IRA type accounts you may have. For example, your $100,000 account has $20,000 after-tax money and $80,000 pre-tax money. You move $20,000 to a Roth. You didn't move the $20,000 of after-tax money as you hoped; you moved $4,000 of after-tax and $16,000 of pre-tax (the same ratio as the whole account). The end result is you owe tax on $16,000. Instead, you need to separate the pre-tax money from the after-tax money. See if you can move all the pre-tax money into your 401(k) account (which is also pre-tax money). This would leave only the $20,000 of after-tax money in the IRA. You have the equivalent of a Roth, without doing a conversion.

b) NEVER pay the taxes out of the IRA you are converting (especially if you are under 591/2 since you will pay an extra 10% penalty on the money wirhdrawn for taxes). The math does not make sense. Only convert if you can pay the taxes from other sources. You don't need to convert the whole account. If you don't have money to cover the taxes on the whole balance, only convert the amount you can cover.

c) To encourage conversions in 2010, the taxes do not have to be paid immediately. 50% of the conversion will be taxed when you pay your 2011 taxes (as late as 4/15/2012) and 50% in 2012 (as late as 4/15/2013). Of course, the tax rates might be higher then!

d) Roth IRAs do not work if you intend to leave your IRA to charity. The charity doesn't have to pay tax, so would benefit from receiving the full pre-tax amount. from the traditional IRA.

e) Pay attention to the tax rate you will pay on the conversion. You don't want to be pushed into a higher tax rate or to incurr Alternative Minimum Tax (AMT). For instance, if a married couple has income of $110,000 and is in the 25% tax bracket, they could convert $25.000 and still be in the 25% tax bracket (which goes up to $137,050).

f) Open a Roth, even if it is with only a small amount of money. It starts the five year clock ticking, which applies to all the money in the account, not just the startup amount.

g) Always open a new Roth account to receive the conversion. If your investment tanks and you need to reconvert back to a traditional IRA, this will simplify things. Once the time for recharacterization has passed, it is OK to consolidate the separate Roth accounts.

h) OK, so you owe tax on the converted amount. Can you offset the tax bill in other ways? For example, by taking any capital losses, or non-refundable tax credits, that may be available to you.

Roth conversions are complex. Call 408-725-7135 for a one-hour appointment to analyse your situation using software that provides 'real world' results.

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