This Roth Trick Is a Sure Thing

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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.

What's going on with this market? Paul Elliott explains why it's time to go short again.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.

Fool contributor Dan Caplinger thinks a recharacterization option for ordinary life would be absolutely fabulous. He owns shares of the iShares Barclays TIPS Bond and Vanguard Emerging Markets Stock ETFs. The Fool owns shares of Vanguard Emerging Markets Stock. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy always delivers the goods.

Read/Post Comments (8) | Recommend This Article (16)

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  • Report this Comment On August 23, 2010, at 6:52 PM, JohnBledsoe wrote:

    I agree that everyone should convert all of their IRA and qualified funds now by asset class into separate Roth IRAs. There is no risk as you may unconvert or recharacterize up until October 17th of 2011! You may analyze the Roth accounts next year after you know more about future income tax rates and account performance. I go through the step by step logic, math and process in my latest book, The Gospel of Roth (Amazon).

    Great article. As the preacher said "Convert"!

  • Report this Comment On August 24, 2010, at 9:54 AM, iamgischmid wrote:


  • Report this Comment On August 24, 2010, at 9:19 PM, MDexpat wrote:

    There is just one problem with this thesis. Dan has not accounted for political risk. Though the recharacterization is a nice feature, it only offers protection from political risk for a year. The problem with Roth is that it offers a benefit in the future, a benefit that can be taken away with a simple change in the tax law.

    We are living in a country facing a government deficit of 10% of GNP with no end in sight. Sooner or later, Democrat or Republican the government is going to have to come to grips with its long-term debt problem. Changing IRA (traditional or Roth) tax law is an easy place to find additional revenues. Why; because IRA tax law is abstract for most individuals. Changes in IRA laws do not have an immediate impact on your take home pay. Roth IRAs are particularly vulnerable as the promised benefit is years in the future.

    You don’t think it can happen? Take a look at what Australia did to expat Super funds. I know from personal experience. I was forced to liquidate my Super at a capital loss, and to add insult to injury, I had to pay a 30% tax penalty fee for liquidating my account early (even though I was forced to liquidate by legislative mandate).

    Dan you can act on the assumption that the government will honor its promises, as for me, In an era of enormous deficits, I think I will maintain a healthy skepticism of the sustainability of government promises of tax free income in the future. I am willing to bet my money that the ultimate viability of the tax advantage of Roth accounts is currently grossly over-estimated.


  • Report this Comment On August 25, 2010, at 10:27 AM, talotu wrote:

    I agree that the future benefits of ROTH may be grossly underestimated. One thing that wasn't mentioned by the last comment was changing ROTH rules is one of the easiest ways to "tax the rich".

  • Report this Comment On August 25, 2010, at 11:49 AM, Knightmare535 wrote:

    Maybe I'm missing something with the discussion on Roth vs Traditional, but it seems to me like the only consideration here is that with a Roth I'm betting that I'll be in a higher tax bracket when I'm retired than when I'm working. That would take either very significant tax increases (possible) or some fantastic investments by me (possible but not probable). For comparison, I assumed I had $1000 to invest, for 10 years, getting 8% return, and in a 10% tax bracket:

    Traditional: $1000 x 1.08^10 (returns) = 2158.925. Pay 10% tax in future gives $1943.032

    Roth: $1000 x .90 (pay tax now) x 1.08^10 = 1943.032.

    By the math, I get exactly equal numbers on either type. Therefore, the decision is based entirely on whether I think I'll be in a higher bracket now or in retirement, of if the rules will change like MDexpat suggested. Am I missing something?

  • Report this Comment On August 26, 2010, at 10:52 PM, KilroyRus wrote:

    You are betting that your returns on the investments will avoid an increase in your tax bracket. We cannot assume that the tax brackets will be the same as now, in fact they may be increased as soon as this year. So the Traditional IRA assumes the risk of RISING Tax brackets/taxes, while the Roth IRA theoretically takes that away, but as pointed out above does not mean that Congress could not in the future enact a "Captial Gains" tax to be applied to Roth IRAs that taxes your profits vs the basis of your Roth Account. This is a very good possibility, and maybe the unspoken catch to the gift from Congress to offer everyone the chance to make this Roth conversion at this time.

    Maybe if its too good to be true ...

    Then again, we are dealing with Congress, not a Snake-oil salesman.

    Then again ....

  • Report this Comment On August 27, 2010, at 6:07 PM, easyavenue wrote:


    I've forgotten exactly why Congress came up with the Roth IRA? I believe it was because not enough people were saving for retirement outside of 401Ks, especially the 'little guy' including small business owners and employees? As such, Roths were thought to help relieve the future burden on Social Security? Isn't that also why the new law requires retirement benefit contributions? But wasn't there also a lot of pressure on Congress to act? I don't recall by whom, or why....

    I agree that Congress goes whichever way the wind blows, or special interest groups, and I have no confidence they will do what is best for the average Joe. [We have GOT to GET RID of obstructionist and sum-zero politicians.!] But I also think if they take away the benefit of the Roth without grandfathering and replacing it with something else, they know they will never be re-elected. And they'd face a very unhappy populus. So I disagree that taxing your Roth is a "very good possibility." Hope I'm right. Or buy gold?

  • Report this Comment On August 30, 2010, at 8:38 PM, MDexpat wrote:


    The Australian Government proved, last year, that you can easily legislate negative changes to retirement accounts (called Super Annuation in Australia) with a minimum reaction from the general public. Why? Because retirement accounts are an abstraction. Changes to retirement accounts change future income and have little impact on income today.

    Roth IRAs are particularly vulnerable in this regard. Take your savings now while you can get them. The future is unknown so making investments in anticipation of benefits in the distant future involves more risk than taking those benefits today. Any calculation on the benefits of Roth IRAs requires a risk discount. If you do not assume a risk dicount, you are overstating the benefits of Roth.

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