Take a Mulligan on Your Losing Roth Conversions
Each year millions of Americans make New Year’s resolutions in order to try and avoid the mistakes of the past. But that doesn’t mean they can undo the past. They are still living with the consequenses.
However, in retirement planning, it is possible to undo the mistakes of the past, with up to 21 and one half months of hindsight. If you make a Roth conversion on January 2nd you have until October 15th of the following year to undo, or recharacterize, the conversion. That gives you up to 21 and one half months to make a final decision on a conversion. This is like receiving a free long-term option on the converted amount and provides great financial flexibility you can put to your advantage.
How Recharacterization Works
Consider the S&P 500. The S&P consists of 500 large-cap stocks grouped into sectors. Since 1950, the S&P 500 has gone up as much as 65.7% and down as much as 40.0% in the 21 and a one half months after the New Year. In the case where the S&P went up, the saver could keep the conversion, keeping $1.66 in Roth assets while only paying tax on $1.00 of conversion. At the other extreme, the saver could recharacterize the 40% losses and pay fewer taxes on a smaller conversion at some point in the future. In the most recent period where data is available the S&P 500 went up 32.9% from January 2012 to October 15, 2013. This is a good return for the converted assets, but it could be even better.
Even Better, Multiple Mulligans
For the 2012 conversion window the two sectors that produced the most extreme performances were the S&P Pharmaceuticals Select Index, up 68.3%, and the S&P Metals and Mining Select Index, down 46.0%. Rather than doing an all-or-nothing conversion, think how much more could be gained by converting the Pharmaceuticals index sector, and recharacterizing the Metals and Mining sector. The IRS has disallowed cherry picking certain positions, but, it does allow a strategy called segregation which enables you to keep some positions while recharacterizing others.
In the May-June 2007 issue of the Journal of Financial Planning Robert Keebler and Stephen Bigge published a paper on Roth conversion and proposed the Roth Segregation Strategy (RSS). When utilizing RSS, the saver splits his/her IRA into different accounts and converts it into several Roth accounts. Each Roth account holds a different portfolio. The total amount converted is more than the amount the saver would normally convert. The assumption is that some conversions will not be profitable and will be recharacterized. After 21 and a half months, the saver makes a final choice on what percentage of each account to recharacterize. The strategy allows the saver to take advantage of the volatility and difference in returns of different securities.
The benefit is that even if it is not normally advantageous to make a conversion (like for someone in a top tax bracket), if the return on the portfolio in one conversion account is high enough, it will be worth keeping. If not, the saver can recharacterize the entire account.
To explain this strategy a little better, there is an example from Bad Money Advice, which explains the Roth Roulette segregation strategy. In it, the author provides the example of investing on a Las Vegas Roulette table which is paraphrased here: Suppose an investor has $380,000 available in an IRA and was able to “invest” it in a Las Vegas casino – specifically in a game of Roulette. At the Roulette table, the saver could place $10,000 on every number (1-36, 0, and 00) for a single spin. The result would be an account now worth $360,000, which should probably be completely recharacterized. On the other hand, if each number got its own account with $10,000 in it, one account will end up with $360,000, and the rest will end up with $0. The 37 accounts with $0 would be recharacterized, and the one with $360,000 will remain converted.
The cost of this conversion is the taxes on a $10,000 conversion, not on $380,000. At the top marginal rate of 39.6%, this tax amounts to $3,960 – a small amount to pay for $360,000 in tax free growth and distributions. In contrast, if the entire $380,000 were taken out over time at a 10% tax rate, only $342,000 would be available for spending. This is opposed to $356,040 achieved through RSS. Even when assuming two extremes in tax rates and the Las Vegas vig, RSS clearly provides a distinct financial advantage.
How to Improve on the Basic Roth Segregation Strategy
Before hurrying to employ RSS, it should be noted there are two deficiencies in the Keebler-Bigge strategy. The first, Keebler and Bigge do not make any recommendations on how much to convert in a segregation strategy. The general idea is that the amount should be more than the target conversion amount. The main challenge with larger conversions is in paying estimated taxes and avoiding estimated tax penalties. If the saver pays too much, they are making an interest-free loan to the government and forgoing gains in their taxable portfolio. On the other hand, making too low of an estimated tax payment will result in interest and penalties.
The second deficiency is a lack of recommendation on the recharacterization percentages for each account. The lack of recharacterization amounts proves to be a more vexing problem. It seems obvious that winners and losers at the extremes should be kept and recharacterized respectively, but when the returns are closer to the long-term expected average, the exact amount is difficult to discern. Optimized Financial System’s SLiP™ Roth Conversion Engine provides answers.
Using SLiP™ to Plan Conversions and Recharacterizations
Determining how much to recharacterize is a simple five-step process:
- Run the SLiP™ engine and determine the optimal amount to convert in 2014.
- Note: This amount is going to be much lower than the amount actually converted into the segregated accounts. The estimated taxes paid should be more than the taxes required to pay for the recommended conversion. The exact amount is dependent on the expected volatility of the converted assets. As a rule of thumb, the saver should pay estimated taxes on the estimated conversion with his/her first estimated tax payment.
- In a perfect world, each holding should be converted into its own account. A more practical solution is to create about 5 accounts and convert the top five holdings. A financial planner can also help split up an index such as the S&P into different sectors. This way the overall volatility will be same, but the individual holdings will be more volatile and offers more potential for outsize profits.
- Prior to the April 15th deadline for taxes in the following year, the saver will use the SLiP™ engine to determine the recharacterizations for the segregated accounts that are not likely to be kept on October 15th.
- In October 2015, with 21 and one half months of returns available, re-run the SLiP™ engine to determine the final recharacterization percentages for each segregated account.
Conventional wisdom says that if the tax rate on distributions in the future is going to be higher than the tax rate on a conversion in the present, then a conversion makes sense. Using segregation strategies as well as taking into consideration the tax drag on assets in taxable accounts, one can see that “conventional wisdom” is no longer valid at the start of this New Year. For the savvy saver, a Roth Segregation Strategy Roth Conversion provides a great opportunity to use volatility as a means to increase after-tax wealth – a worthy New Year’s resolution indeed!
Happy New Year!
Optimized Financial Systems