Last month we covered the basics of a Roth IRA conversion. (If you missed it, Read it Here). This month we'll discuss a few more mechanics of converting along with conversion strategies to maximize tax savings. Let's get to the Q&A...
1. First, can you provide clarity on the timing of the conversion and when it’s income for tax purposes?
Income from a Roth conversion is taxable in the year of conversion (e.g. Income from a conversion done during the 2017 calendar year is reported on the 2017 tax return filed in 2018).
2. The undo feature from the last Q&A sounds appealing. Can you talk more about that?
The technical term is recharacterize. Let’s say you convert $20,000 of IRA to Roth in 2017. When your CPA is preparing your 2017 tax return you find out the conversion cost (tax) is 40% when you thought it would only be 25%. You decide you don’t want to pay 40%. You can recharacterize (undo) the conversion by moving the $20,000 plus related earnings (or loss) back to traditional IRA.
3. Related earnings? What’s that?
If the $20,000 grows to $21,000 you have $1,000 of related earnings. If you undo the full conversion then you must move the entire $21,000 back to IRA. If you only moved $20,000 back it would’ve resulted in moving $1,000 to Roth without paying any tax (which the tax law does not allow).
4. Okay, I understand the mechanics. Can you fill me in on some Roth conversion strategy?
Definitely! Multiple conversions using different investments can yield significant tax savings. Assume $60,000 is the amount of conversion you want to do in 2017. Consider doing three separate $60,000 conversions into separate Roth conversion accounts (let’s call them Roth #1, Roth #2, and Roth #3).
5. Interesting. Why would I want three separate conversions?
The three separate conversions should have different investment objectives. For example, Roth #1 could be a U.S. stock fund. Roth #2 could be a foreign stock fund. Roth #3 could be a bond fund. This will help to isolate an investment that outperforms from one that underperforms.
6. I don’t get it. Why not combine them all into one conversion account?
You can’t cherry-pick what you want to undo from a single Roth conversion. Assume a scenario where U.S. and foreign stocks are down 20% and bonds are up 5%, you’d want to keep the bond fund (Roth #3) converted and undo #1 and #2. If everything was combined into one conversion, you would undo 2/3rd of the combined (lesser) value.
7. I think I got it. Can you run through the numbers?
Sure. Roth #1 and Roth #2, down 20%, would be worth $48,000 each while Roth #3 (up 5%) would be worth $63,000. The total of the three conversion accounts is $159,000. You undo #1 and #2 (totaling $96,000) and put those back to traditional IRA. You are left with $63,000 in converted Roth (in #3). Remember you pay tax on the value at conversion, which was $60,000. So, you are $3,000 ahead of the game.
8. I follow. So, how is that different than if it was only in one conversion account?
With one conversion account the value would be the same $159,000. Assuming the same goal of keeping $60,000 of the original $180,000 converted, you would move 2/3rd of the value back to IRA and keep 1/3rd of the current value in Roth. That would mean $106,000 back to traditional, leaving only $53,000 in the Roth conversion. So, without the multiple conversion strategy, you would still pay tax on $60,000 but only be left with $53,000 in Roth conversion. Not a good answer.
9. Thanks for clearing that up. Anything else we should know?
You can do more than three Roth conversions. Consider separate conversions for different individual stocks if that’s what you own. Or maybe you have sector funds that you can use. And don’t stop with one year. Once the next year starts up, go ahead and do some more. Remember to keep them separate, though. Don’t commingle Roth conversion assets until you know for sure that you want to keep them converted. Consider keeping a Roth conversion “home” account where you move converted values that you decide to keep.
10. Wow. I didn’t realize how much could be done with Roth conversions. Any last words?
Have fun with it. It sounds like a bit of work, but having a CPA and financial advisor that work together to execute the conversions and monitor performance to determine what to keep and what to undo makes the process seamless.
If you missed part 1, here are the basics on Roth IRA Conversions.