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Every so often, you'll find an opportunity that looks too good to be true. Most of the time, it is. But occasionally, great deals do exist -- provided you have the courage to jump on them before they disappear.
Roth conversions are exactly that sort of opportunity. Although converting your traditional IRA to a Roth IRA used to be prohibited for those making more than $100,000 a year, changes in tax law that took effect at the beginning of this year now allow anyone to do a Roth conversion, whatever their income. And thanks to a unique provision in that tax law, Roth conversions represent a no-lose scenario.
Why a Roth?
To understand just how good this deal is, you must first understand the benefits of a Roth IRA. Regular IRAs give you tax deferral, meaning that you don't have to pay taxes on the income your IRA assets generate year in and year out on your investments. After you retire, though, you'll pay tax on the distributions you take from your traditional IRA.
With a Roth IRA, though, those distributions are completely tax-free. With the prospect of higher tax rates looming large for 2011 and beyond, the prospect of tax-free retirement savings looks more promising than ever. So what's the catch?
There is a price for doing a Roth conversion. You must include whatever amount you convert as taxable income, usually in the year you convert. For 2010 only, you have an option to defer including the converted amount as taxable income until 2011 and 2012, putting half of the converted amount on each year's return. Nonetheless, you'll see your taxes go up in the year you convert.
Why's it a sure thing?
Whether a conversion works out well depends on what happens to your investments after you convert. If your investments soar, then you've sheltered those gains from tax completely. But if they crash, you'll pay inordinately high amounts of tax, because your tax liability is based on the value of the money at the time of conversion.
What turns an already good deal into a great deal is a special provision for Roth conversions. If things go badly, you can do something called recharacterizing your conversion; in simple language, this means you can undo the whole thing and pretend it never happened.
If the Roth falls in value, you can get your IRA provider to switch the money back to a traditional IRA. For tax purposes, the whole thing is completely forgotten. You even get a long period of time -- until Oct. 17, 2011 for 2010 conversions -- to finish a recharacterization.
The winning strategy
Even better, if you divide your assets into multiple Roth IRAs, you can recharacterize whatever portion of your conversion performs badly, while keeping the good parts. That suggests a useful strategy, which I'll illustrate using ETFs:
Step 1: Arrange to have your traditional IRA converted into multiple separate Roth IRA accounts, each with an amount that fits with your overall asset allocation strategy.
Step 2: Make these investments in your various accounts. Here's an example using four accounts:
- U.S. stocks: In one account, buy either Vanguard Total Stock Market (NYSE: VTI ) or a combination of SPDR Trust (NYSE: SPY ) and iShares Russell 2000 ETF (NYSE: IWM ) .
- International stocks: In the second account, buy iShares MSCI EAFE (NYSE: EFA ) and Vanguard Emerging Markets Stock ETF (NYSE: VWO ) .
- Bonds: Put shares of Vanguard Total Bond Market (NYSE: BND ) and/or iShares Barclays TIPS Bond (NYSE: TIP ) in the third account.
- Other assets: Use the fourth account to make aggressive investments, either in individual stocks or in specialty ETFs like the SPDR Gold Trust.
Step 3: Evaluate each account before the recharacterization deadline. Recharacterize your losing accounts while keeping your winners.
You can divide your converted assets into however many accounts you choose. The more you create, of course, the more paperwork you'll need to track -- but conversely, you'll also have a greater ability to pick out losers while sticking with your winners.
Make the most of your conversion
The ability to recharacterize should help you feel comfortable converting to a Roth. No matter what, you always have the ability to undo the conversion, whether your tax situation changes or your investments perform poorly. By using separate accounts, you can control your tax liability while making sure you don't get dinged by adverse market conditions.
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Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.