Converting to a Roth IRA? Read This First

Financial magazines, newspapers, and business news channels are abuzz with stories reporting the new opportunity for high income individuals to convert their traditional individual retirement account (‘IRA’) into a Roth IRA starting in 2010.

Until now, high-income earners were not allowed to convert traditional IRA’s into Roth IRA’s. However, there is no hard and fast rule that can fit into a sound bite for determining when, or if, a conversion is suitable. Instead an in-depth analysis of an individual’s specific facts and circumstances must be completed.

Assuming that a conversion has been deemed desirable, there are strategies, based on the ability to have a ‘do-over’ on a conversion, which can be implemented to minimize the income taxes due. These strategies are particularly useful during volatile markets, such as those we have recently experienced.

Some Background

Generally, when an individual converts a traditional IRA funded solely with deductible contributions, he or she is required to include in gross income the value of the assets transferred at the date of conversion. In essence, the individual will forego the income tax deferral and pay the tax now on the current account value, so that all future distributions are income tax free.

Conversion Example

Assume an individual converts a traditional IRA comprised of diverse asset classes and investments with a total value of $1,000,000 to a Roth on January 1, 2010. Further, assume that in October of 2011, the Roth is worth only $925,000 in total. Despite the 7.5% decline in market value, the individual is required to pay tax based on the much higher conversion date value of $1,000,000. The tax law, however, provides relief for just this situation.

The Internal Revenue Code allows individuals to undo a conversion from a traditional IRA to a Roth by what is known as a recharacterization. Once a Roth conversion has been recharacterized, the individual can then reconvert to a Roth after waiting at least 30 days from the date of recharacterization. Recharacterizations must be completed by the due date of the tax return, including the allowed period of extension, for the year the conversion took place. However, an individual cannot convert, recharacterize, and reconvert in the same calendar year.

In our example, the individual has until October 15, 2011 to elect to recharacterize the Roth conversion done on January 1, 2010. Even if an individual files their tax return for the conversion year by April 15, 2011, the IRS allows an additional six months to recharacterize a Roth conversion. Assuming that the individual elects to recharacterize, he or she will be able to reconvert the traditional IRA back to a Roth after waiting 30 days, at a value much closer to $925,000 (unless of course, the markets rebound dramatically in the 30 days following the recharacterization). Also, it is important to factor into the analysis that income tax rates in 2011 may be higher than in 2010, which could offset some of the benefit of a potential recharacterization.

Account Segregation Strategy

Let’s revisit the previous example to see how using this recharacterization provision can generate additional tax savings for conversions that are implemented using segregated accounts. Instead of converting the entire account as one sum on January 1, 2010, the individual could instead elect to split the IRA into 4 separate accounts and execute four conversions of $250,000 each. This allows the individual to track the performance of the converted Roth IRAs in separate buckets and only recharacterize the poorly performing account (or accounts). Although the combined accounts can be diversified across various uncorrelated asset classes, ideally each individual account should only contain assets that are highly correlated. Isolating the correlated assets in separate accounts reduces the risk that the gain from an unusually high performing asset class will be offset by a poor performing asset class in the same converted account.

For instance, assume that by October of 2011, one subaccount grew 30% to $325,000, whereas the other three declined in value such that they more than offset this growth (see table below). In total, the individual still has a 7.5% loss and ends up with total portfolio worth $925,000 in October 2011. However, since the conversion was performed using segregated accounts, the individual can elect to recharacterize only the poorly performing Roth IRAs.

Account     Year 1 Re-Convert   Year 2
  1/1/2010 Gain/Loss 10/15/2011 11/15/2011 Gain/Loss 10/15/2012
1 250,000 30.0% 325,000      
2 250,000 -10.0% 225,000 225,000 12.0% 252,000
3 250,000 -20.0% 200,000 200,000 25.0% 250,000
4 250,000 -30.0% 175,000 175,000 30.0% 227,500
  1,000,000 -7.5% 925,000 600,000 21.6% 729,500
    (75,000)     129,500  
Converted $250,000 in year 1 and $600,000 in year 2. Over two years, paid tax on the conversion of $850,000 in traditional IRA funds.

The account that grew 30% to $325,000 can remain a Roth, and the individual can lock in the conversion date value of $250,000 for income tax purposes. The individual will elect to recharacterize the three poorly performing IRA’s that dropped in value and attempt a re-conversion 30 days later. The individual can repeat this process of recharacterizing the ‘losers’ and converting the ‘winners’ in subsequent tax years until the entire traditional IRA has been converted to a Roth. In the hypothetical example above, the three IRA’s re-converted in November 2011 bounced back in 2012, in which case the individual would not recharacterize any of the accounts.


As this example illustrates, segregating traditional IRA accounts and taking advantage of the opportunity to ‘re-do’ the conversion can result in significant tax savings on a Roth conversion. Even though the original conversion value was $1,000,000, the individual only had to pick up $850,000 in income. WTAS is prepared to assist you in determining whether a Roth conversion is appropriate based on your individual situation and goals, as well as help develop strategies for minimizing income taxes should you decide to convert.