The benefits of creating a stream of tax-free income during retirement is key to most successful retirement income strategies, and a Roth conversion that allows the client to “undo” the transaction if investments perform poorly is an attractive option for accomplishing this goal. However, despite the benefits that recharacterizing a Roth conversion can offer, this route can sometimes function as a double-edged sword by erasing the gains on successful investments within the account. Despite this, a carefully planned Roth conversion strategy can help clients avoid this risk: by using separate accounts, clients can maximize the value of their converted retirement funds and simultaneously take full advantage of the ability to recharacterize underperforming Roth investments.
See also: Why Roth IRAs matter
The multiple Roth account strategy
For clients looking to make substantial Roth conversions, the ability to recharacterize converted funds in the event of underperforming investments may seem to provide a type of safety net to guarantee the strategy’s success. Even with this, though, clients may choose to recharacterize only a portion of the converted funds; they are not permitted to choose which particular investments within the overall account will be recharacterized, which can result in the client missing out on some of the gains produced within the account.
Instead, the client is required to recharacterize a pro rata portion of all of the investments in the Roth account, regardless of whether the particular investment produced a gain or a loss.
This result can be avoided because there is no limit to the number of Roth accounts into which traditional IRA funds can be converted. Therefore, for some clients it may be beneficial to divide the traditional IRA funds that they wish to convert among several separate Roth accounts, based on asset type or even by individual investment. If the client uses multiple accounts and one investment performs poorly, the client will simply recharacterize the account in which that investment is held, keeping the gains on all other accounts.
After the recharacterization deadline has passed (typically, October 15 of the year following the conversion), the client can choose to consolidate the Roths into a single account that is easier to manage.
Despite the substantial tax benefits that come with Roth IRAs, there are many reasons why a client might want to undo a conversion and transfer funds into a traditional IRA.
If your client’s Roth IRA performed poorly since it was converted, it might not be worth the tax liability, which is imposed upon the total value converted even if that value decreased following the conversion. For example, if a client in the 35 percent tax bracket converted $100,000 into a Roth IRA in 2013, and the account depreciated in value to $70,000 (though this would represent quite a decrease), the client will owe taxes on the $100,000 that was converted, regardless of the fact that the account is now worth much less. The client would likely benefit from recharacterizing the Roth IRA and moving the funds back into a traditional IRA to avoid the tax hit.
A client who has unexpectedly jumped into a higher tax bracket may want to recharacterize a Roth conversion because keeping the conversion would mean that he must pay the taxes on the account value at a higher than anticipated rate. Further, clients who had unexpected expenses during the year and simply cannot afford to make the tax payment can also recharacterize the funds and defer the tax liability to a later date.
It is important that each client gain professional advice in establishing multiple Roth accounts, paying special attention to the cost of establishing these accounts relative to the amounts converted. However, for clients looking to make substantial Roth conversions and take full advantage of the possibility of recharacterization, a multiple Roth strategy can provide maximum value.
For previous coverage of Roth conversion strategies in Advisor’s Journal, see 401(k) vs. IRA: The Real Roth Conversion Question.
For in-depth analysis of Roth IRAs generally, see Advisor’s Main Library: Roth IRAs.
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