You’re probably well aware of what a Roth IRA is. You may even be aware that you can convert your regular IRA’s into a Roth IRA without penalty! A few years ago there were income limits in place to do Roth IRA conversions. Currently you can convert IRA’s to Roth IRA’s at any income level.
This process is called a “Roth IRA conversion”. You simply pay ordinary income tax on amounts converted from IRA to Roth. It may seem crazy to “pre-pay” your taxes, but if done right these conversions have amazing financial benefits!
There is a little known strategy of using multiple conversions and strategic recharacterization. “Recharacterization” is the process of “undoing” a “Roth IRA conversion”. Sounds complicated I realize, but this allows you to cherry pick which converted accounts you want to keep, and which you don’t.
The benefit of using this “multi-bucket” strategy is the tax savings. In todays retirement world it’s critical to squeeze every last dime from your finances. Saving hundreds to thousands each year in taxes provides amazing value over long periods of time!
Why is the Roth IRA so powerful?
Let’s recap the basics of what’s involved with the multi-bucket Roth conversion strategy. The Roth IRA on it’s own is amazingly powerful as a retirement planning vehicle.
The Roth IRA:
- Provides tax free withdrawals of principal at any time
- Provides tax free withdrawals of investment growth if the account was held more than 5 years and you’re age 59 and 1/2 or older
- Has no required minimum distributions at age 70 and 1/2 (unlike regular IRA’s)
The Roth IRA is a fantastic retirement savings tool! Consider we’re currently at historically low income tax rates. If tax rates rise (and with 19 trillion dollars in debt this is likely) the Roth conversion will be even more powerful! Just imagine withdrawing funds from you IRA in 5 or 10 or 20 years and paying 25%, 30%, or more! Your Roth IRA will be looking pretty darn good then.
Another important aspect of the Roth IRA is that they’re great assets to leave to your heirs. In retirement you may be in a low income tax bracket, but your heirs are likely in their prime earnings years and in much higher tax brackets.
When you die your IRA or Roth IRA goes to your heirs. They can withdraw those funds within 5 years or as an income stream over their lifetimes. If they’re paying 30% in taxes and you’re paying 15% in taxes, your heirs will get a lot less of your hard earned legacy! Just ask yourself the question “is it better for you to pay 15% now or your heirs to pay 30% later?”
The Roth IRA avoids this problem. By leaving your heirs a Roth IRA you’re giving them the gift of a tax free income stream that stretches throughout their lifetime.
The best part is you can convert your IRA to Roth IRA at your current tax rate. These Roth conversions are incredibly powerful if done properly.
What is a Roth conversion?
Once you’ve decided to beef up your Roth IRA accounts you’ll need to consider a Roth conversion. A Roth conversion is simply the process of moving money from your IRA into a Roth IRA.
This can be done fairly quickly and easily with your financial advisor or IRA custodian’s help. It takes a bit of paperwork, and you need to pay attention to the amount you’re converting, but it’s pretty painless.
The amount you convert from IRA to Roth IRA becomes taxable. This means if you convert $50,000 from IRA to Roth IRA you’ve effectively added $50,000 in ordinary income to your tax return. Why would you want to increase your taxes you may think? Again, the tax free nature of a Roth IRA is incredibly powerful looking into the future.
An IRA to Roth IRA conversion forces you to pay taxes at your current rates. While it’s never fun to pay taxes, consider what happens to your account values over time assuming nominal growth rates.
Let’s say you’re in the 15% tax bracket now and you convert $50,000 of IRA to Roth IRA. You’ve paid $7,500 in taxes for the conversion.
Now let’s assume you wait 10 years to convert your IRA to Roth IRA. Along the way your IRA grows at just 5% per year. You’re now converting $77,566 in value at 15%. That’s a tax bite of $11,634!
How much do you want to pay in taxes?
Would you rather pay $7,500 in taxes now or $11,634 in taxes later? It’s up to you how much in taxes you want to pay. Everyone has their own financial situation. If you’re inclined to do any sort of IRA to Roth IRA conversion it pays to consider it sooner rather than later.
Side Note: It really pays to do a Roth IRA conversion if your IRA account is down significantly. The investment assets you own (and will continue to own) are at depressed values. When those assets rebound over time all of that growth will be in the Roth IRA and tax free in the future! For the seasoned investor Roth conversions when markets are depressed are an amazing opportunity!
What if I change my mind on the Roth Conversion (recharacterization)?
I’m glad you asked! This entire strategy is hinged on the ability to undo what you may do!
Let’s say you did a Roth conversion of $50,000 in June and had some unexpected large expenses in September. These expenses require IRA draws which will push your tax bracket up to a point the Roth conversion becomes unattractive.
Have no fear, you can “recharacterize” the conversion!
Recharacterization is the process of “undoing” the Roth conversion. You simply tell your financial advisor or IRA custodian you want to void or reverse the Roth conversion. They then take the Roth account and put it back into an IRA. For IRS purposes this effectively erases the transaction as if it had never happened.
You can recharacterize a Roth conversion at any time up to your tax filing deadline plus extensions. Basically, you have until October 15th of the following year to recharacterize. For example, if you do a Roth conversion in July of 2016 you have until October 15th of 2017 to undo it.
You don’t need to file an extension to push the recharacterization to October 2015. For various reasons you may want to recharacterize earlier.
In this multi-bucket Roth conversion strategy you will intentionally recharacterize at least one Roth IRA. As such it may be appropriate to file an extension for your tax return. If you’ve already filed and paid your taxes and want to recharacterize, you’ll need to file an amended return.
Be wary multiple year Roth conversions
There is a special rule regarding conversions after recharacterization. Let’s say you recharacterized a Roth conversion and you want to do another conversion. You have to wait:
- the later of 30 days after the recharacterization, OR
- the year following the year of the Roth conversion.
For example, let’s say you did a Roth conversion in January of 2016 and by October you know your income will be high enough to push you into a tax bracket making the conversion undesirable. You must wait until January of 2017 to do another Roth Conversion. Conversely if you wait until the following year to recharacterize – let’s say March 15th of 2017 – you must wait at least 30 days after that recharacterization (April 15th, 2017) to do another Roth conversion.
Be very aware that this strategy can implode if not done properly! You must pay very specific attention to the rules. If you don’t follow the rules you’ll be subject to the whims of the Internal Revenue Service.
It’s fairly simple to recharacterize a Roth back into an IRA provided it’s done as a separate account. It’s much more difficult to recharacterize if you did your Roth conversion into an already existing Roth IRA because a pro-rate share of gains and losses must also be recharacterized.
Example: Suppose you have a $400,000 IRA and a $100,000 Roth IRA and you decide to convert $50,000 of a small cap growth fund from your IRA. Rather than establishing a separate Roth account from your currently open Roth, you simply transfer $50,000 of the fund into your Roth.
6 months goes by and your small cap growth fund is down 50%. If you keep the Roth conversion you’ll owe taxes on $50,000 when the value of your conversion is only $25,000. If you’re in the 15% bracket this amounts to $3,750 in extra taxes you don’t need to pay!
Now assume that the rest of your investments in the established Roth IRA did well. Rather than being down 50% they’re actually positive by 10%.
So your Roth IRA looks like this:
- The established Roth is $100,000 times (1+.10) = $110,000
- The converted Roth amount is $50,000 times (1-.50) = $25,000
- Total value is $110,000 + $25,000 = $135,000
- Percentage loss is $15,000 of the $150,000 or 10%
If you wanted to recharacterize you can’t put back the $50,000 that lost. Rather, since the account overall was down a total of 10% you can only undo $45,000 of the conversion (the original $50,000 minus the aggregate 10% loss.
This works the same way if the account is positive in total. Regardless of how the shares you transferred on the conversion did, you must recharacterize a pro-rata amount which takes into account the total gains and losses in the Roth IRA over the time period.
The right way to do a Roth IRA conversion
It’s much better to establish a completely new Roth IRA. This makes recharacterization relatively quick and simple. It also avoids these complex calculations.
In the example above if you had converted the $50,000 of small cap growth fund into a completely separate Roth IRA you could have easily recharacterized the $25,000 in value back to an IRA. By doing this you would save yourself the taxes you paid. You’d also now have the opportunity to convert IRA to Roth IRA again. Who wants to pay $7,500 in taxes when you only need to pay $3,750 anyway?
Multiple Roth conversions in the same year
The ability to recharacterize a separate Roth account after it’s been converted fairly easily gives us an entirely new planning opportunity – the strategic multi-bucket Roth conversion. We’ll call it the SMRC in short.
The SMRC allows you to really turbo-charge your Roth conversions if the dollar amounts are large enough. This isn’t a particularly valuable strategy for a $10,000 Roth conversion, but for a $50,000 conversion it’s powerful!
Here’s how Roth recharacterization works:
- Decide how much IRA you want to convert to Roth IRA, let’s say $50,000
- Convert multiple buckets of $50,000 into separate Roth IRA’s
- Invest each bucket distinctly different (i.e. one in stocks, one in bonds, one in REIT’s etc.)
- See which bucket performed the best prior to the recharacterization deadline
- Recharacterize the poorly performing buckets back into the IRA
- Wait the minimum time period to do another Roth conversion
You can do as many buckets as practical. 2 buckets, 4 buckets, 6 buckets – whatever is practical for your situation. Remember the goal is to do a $50,000 Roth conversion, so each bucket should be filled with $50,000 from your IRA. If your IRA is $200,000 you’ll be limited to 4 total buckets, and so on.
Breaking down the multi-bucket Roth conversion strategy
Take a look at the SMRC infographic attached. It illustrates how the strategy works and how it can save you thousands of dollars in taxes year one, and tens of thousands of dollars over your retirement!
The key to the strategic multi-bucket Roth conversion is having buckets which perform substantially differently from each other. If you buy a balanced mutual fund in each bucket they’ll all perform the same and you won’t reap the benefits from separating out those asset classes.
Correlation factors are quite important here. Correlation is the degree to which one asset class performs relative to another. Stocks perform differently than bonds, commodities perform differently than stocks, and real estate performs differently than stocks, bonds, and commodities.
Within those asset classes – stocks for example – small cap growth stocks perform differently than large cap foreign stocks. With bonds, intermediate term lower credit quality bonds will perform differently than Tbills. It’s the lack of correlation – or negative correlation – that makes this strategy attractive.
For most purposes two buckets – one with stocks and the other with bonds – is a great start. When the conversion amount gets large enough a bucket with small companies and a bucket with international companies may make a nice addition.
A strategic multi-bucket Roth conversion example
Meet Jane. Jane is retired and runs the finances in her household. Her and her husband are in a relatively low income tax bracket right now because they’ve chosen to defer their Social Security income until age 70 to get the magical 8% increase each year they defer.
They’re in a relatively low income tax bracket at this early point in retirement. They’d like to convert as much of their $500,000 in IRA’s as possible to fill up the 15% tax bracket.
She’s run the calculations and doesn’t feel pushing their income into the 25% bracket is worthwhile. The amount she’s come up with to convert is $50,000.
Jane’s multi-bucket strategy
Rather than simply converting $50,000 into one Roth account, Jane uses the SMRC and converts into 4 equal but different Roth buckets totaling $200,000. One has stocks, one bonds, one commodities, and one real estate. Jane knows those asset classes generally have a low correlation to each other, so one of them is likely to win by the time she must recharacterize.
In this case Jane’s stock Roth account performed the best. It was up 10% giving her a value of $55,000 when she only paid taxes on $50,000. The SMRC saved her $750 in taxes ($5,000 times her tax rate of .15%). $750 may not sound like much, but in retirement it can go a long way each year towards helping you enjoy the lifestyle you want.
If Jane had evenly balanced one Roth conversion for $50,000 equally into the 4 asset classes she would have had a loss of $500. She would have paid taxes at 15% on the conversion of $50,000 ($7,500) but should have only paid taxes on $49,500. This is such a minor amount it’s unlikely she would have recharacterized the conversion, but it’s most definitely an opportunity missed.
Roth conversion buckets in summary
There is an amazing amount of financial benefit to be had by properly converting IRA to Roth IRA. If you’re not considering this as a viable strategy you’re completely missing the boat!
Make sure your conversion is big enough. It doesn’t make much sense to convert many smaller buckets of IRA to Roth. $20,000 per bucket would be the absolute minimum, with buckets of $30,000 and more making much more sense.
Consult with your tax advisor first! They’ll ultimately be using this strategy on your tax return, so make sure they’re on board and you’re on the same page!