Trust and Estate Counsel

Tennessee Estate Planning Law

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Roth IRA Conversions-Part 5 - The Significance of Investment Returns During the First 21 Months

This is the fifth article in a series dealing with the topic of converting your traditional IRA to a Roth IRA. For other articles, see:

Part 1 – Reasons to Consider the Roth Conversion
Part 2 – The Recharacterization Option
Part 3 – The Impact of Income Tax Rates
Part 4 – How Long Can You Stretch?
Part 6 – The Impact of Estate Taxes
Part 7 – Ramifications of Charitable Giving
Part 8 - Putting It All Together

Investment performance has extra significance during the first 21 months after a conversion to a Roth IRA. Your investment performance may determine whether you undo the conversion. The recharacterization option allows you to change your mind about a conversion as late as October 15 of the year following the conversion. This means that if you convert in January, you can make the Roth decision after seeing your investment returns over the prior 21 months.

The ability to make your decision after seeing your investment returns allows you to choose the maximum income tax rate that you are willing to pay. Assume that you are in a 35% income tax bracket and are only willing to make the conversion if the maximum tax rate on the conversion is 25%. This means that you will recharacterize the Roth IRA to a regular IRA unless the value of the IRA has grown by 40% during the first 21 months.

Unless you are a fantastic investor, there is a small likelihood of achieving a 40% rate of return on your entire portfolio over a 21 month period. However, you only need to obtain this return on a portion of your portfolio.

For example, assume that you convert an IRA with a value of $600,000 into six separate Roth IRAs with values of $100,000. You choose the overall investments for the Roth IRAs as if they were one account, yet place different asset classes in different Roth IRAs. Splitting your various asset classes into separate Roth IRAs increases the volatility of returns for each Roth IRA without increasing the risk of the overall portfolio. By increasing volatility, you significantly improve the chances of achieving a higher return on portions of your portfolio during the first 21 months.

Assume that the values of the six Roth IRAs after 21 months are $150,000, $130,000, $110,000, $100,000, $80,000, and $60,000. You will keep the two largest Roth IRAs and recharacterize the four with the lowest values. You will pay $70,000 of tax (35% times $200,000) on the two largest Roth IRA accounts with a combined value of $280,000. This represents an effective tax rate of 25%. The overall return on the portfolio was $30,000, which represents an aggregate return of 5%. However, by splitting the portfolio into its separate asset classes, you were able to achieve a much higher return on the portion of the portfolio that you converted.

Derivatives can be used to further increase the volatility among segments of your overall portfolio, without necessarily increasing the volatility of your combined portfolio. Though derivatives are frequently used by hedge fund managers, they are not utilized by many investors because they are less well understood and because they generally receive unfavorable income tax treatment when they are used in taxable accounts. The tax disadvantage is not a concern for Roth IRAs because Roth IRAs do not pay income taxes.

You will need to closely monitor your investments during the 21 month period following the conversion. On December 2 of the year of the conversion, you should consider recharacterizing accounts that have gone down in value. You can then reconvert on January 2 of the following year. On the other hand, if your investments do very well during the first months after the conversion, you might choose to shift the investment mix of the successful Roth accounts to decrease the risk of going backwards during the remainder of the 21 month period.  Similarly, you might shift investments to increase the volatility of accounts that are positive, yet not positive enough to keep the Roth IRA conversion. Ideally, any investment changes made during the 21 month period will maintain your overall desired portfolio allocation.

After the 21 month period, you can combine all of the Roth IRAs that you did not recharacterize and invest the combined Roth IRA account according to your long-term objectives. You will also need to coordinate the investments in your Roth IRA, your traditional IRA, and your taxable investment accounts.

The ability to decide about keeping a Roth conversion after seeing your investment returns will encourage a lot of investors to take a “free look.”  Careful planning with the assistance of your investment advisors is required to take maximum advantage of this tremendous opportunity.