Roth IRA conversion strategies to consider
Now that Roth IRA conversions are open to all consumers, regardless of income, it's time to think about whether you want to convert and how to do it.
Roth conversions are attractive for several reasons. Once you pay the taxes due on conversion, you won't have to pay tax when you withdraw money in retirement, enabling you to sock away tax-free retirement income. Also, unlike with traditional individual retirement accounts, you don't have to take required minimum distributions from Roth IRAs at age 70½, so the money can continue to grow tax-free until you need it (or until your beneficiaries get their hands on it).
Conversion is a pretty straightforward process, but there are some potential issues in the process that could throw a wrench in your plans.
A big wild card is how the markets are going to perform this year. After the stock market dropped like a rock during the financial crisis, you may be wary of paying taxes on assets that could fall in value after you convert. Fortunately, with help from your tax adviser, you can employ several tactics to hedge against that possibility.
In a white paper called "Roth Conversion Strategies: Income and Estate Planning Ramifications," Certified Financial Planner Leon LaBrecque, CPA, outlines several strategies to make a Roth conversion and potentially undo it later so you don't have to pay taxes if the Roth account depreciates.
Undoing a Roth is a process known as recharacterization. When you recharacterize a Roth, you return it to its previous state as a traditional IRA and the IRS refunds the money you paid in taxes at conversion.
One popular strategy LaBrecque notes is setting up "segregated" Roth accounts where you put bonds, stocks and other assets in different Roth IRA accounts. This way, if your stocks or stock funds tank, you can recharacterize those assets without having to redo your other Roths. This could mean setting up several Roth accounts, says Joe Jennings, a senior financial adviser with PNC Bank in Baltimore, Md.
"Because you can't recharacterize portions of a Roth IRA, if you are concerned about specific assets or asset classes losing value later, you can segregate those, at conversion, into several different accounts," Jennings says. "So if they did in fact lose value, you could recharacterize individual accounts."
Segregating by asset class, or even by individual investments such as stocks, would be what LaBrecque calls a "vertically segregated Roth." Another strategy, called a "horizontally segregated Roth," is a layered approach based on "prospective account appreciation." It involves dividing up your assets into one large "base" Roth account and numerous smaller Roth accounts, all with the same asset allocation. The extent of market appreciation determines how many of the accounts get recharacterized. If the market moves are large on the upside, more of the Roth accounts remain Roths.
LaBrecque offers a mathematical formula based on the market's return to help guide investors on how many accounts should remain Roths and how many should be recharacterized. Overall, he describes his system as a way to "take the profits and turn them into Roths."