Wednesday, April 01, 2009

A Roth Conversion Strategy For a Declining Market

With the stock market down, a silver lining recommendation is to consider a Roth IRA conversion of stocks held in a traditional IRA. The common wisdom is that one is only paying taxes on the reduced value of the stock at the time of conversion, and when the market recovers, the gain will be tax free since the stock is held in a Roth IRA. This is a great idea, except when the stock continues to decline after the conversion. In this instance, one is paying taxes on an amount greater than the value of the stock in the Roth IRA.

Tax Consequences of Roth Conversions
Converted AmountValue in FutureAmount that is Taxed
Stock increases in value$5,000$10,000$5,000
Stock decreases in value$5,000$3,000$5,000

Of course, if a decline happens, one can avoid paying the tax by reversing the Roth conversion in a process called recharacterization. Unfortunately, one loses the opportunity to convert further funds to the Roth IRA for 30 days or the next tax year which ever is later. This exact issue happened to us in 2008, causing me to recharacterize my Roth conversion.

In discussions with my financial advisor, he mentioned a Roth conversion strategy that they were using to reduce the risk of paying taxes on losses. They were doing multiple Roth conversions of stock portfolios, and then later choosing to recharacterize the Roth conversion that had declined in value. My build on this idea was to make one of the Roth conversions cash, which would guarantee that at least one portfolio would not decline. Assuming one only wants to keep one Roth conversion for a tax year, the table below show how I would think about keeping or recharacterizing multiple Roth IRA conversions.

Multiple Roth Conversion Strategy
Assets ConvertedConversion AmountFuture ValueRecharterization Decision
Stock Portfolio 1$10,000$5,000Recharacterize
Stock Portfolio 2$10,000$15,000Maintain Conversion
Cash$10,000$10,100Maintain conversion when versus Stock Portfolio 1, Recharacterize versus Stock Portfolio 2

This week I implemented the idea of multiple Roth conversions of equal value with my financial advisor, with one conversion of cash, one conversion of my company stock and one conversion of a managed account. At the end of 2009, I will keep the Roth conversion that is the highest in value and therefore, avoid paying taxes on a conversion amount that is higher than the value in the Roth IRA.

For more on The Practice of Personal Finance, check back every Wednesday for a new segment.

This is not financial, tax, or investment advice. Please consult a professional advisor.

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