Just because a certain transaction is allowed doesn’t mean it’s always a good idea. For instance, the Pension Protection Act of 2006 added the ability to convert a 401(k) from a previous employer to a Roth IRA. Before that, the only option was to convert first to a Traditional IRA, and as you may recall, anyone with an income over $100K was stuck, converting to a Roth wasn’t in the code just yet. Now, however, anyone can convert from their IRA to a Roth IRA and pay tax on the converted amount. You may ask, then, what’s the difference, 401(k) to Roth or 401(k) to Traditional IRA to Roth? Taxes are still due, right?
The major difference is one word – Recharacterization. This may be the longest word I’ve ever written, here or anywhere. For one word, I’ll ask a bit of your time and patience to let me explain what it means and what its implications are. A recharacterization is one of the rare times you are permitted a financial do-over. If you convert any of your traditional IRA to a Roth this year, you have until tax day next year (the normal due date for your return) plus the standard extension. This will be on or just after October 15th of the year following the conversion. A simple form to your broker and you can recharacterize or un-convert any or all of what you converted during that prior year. I’ll share the two simple reasons why you’d want to do this.
Too high a cost. Any conversion is taxed at your marginal rate, which may be a bit of sticker shock. For a couple filing joint, their 15% bracket ends at a taxable income level of $70,700 in 2012. To be clear, this means that if their taxable income this year is precisely $70,700, they paid $15 on the last hundred taxed, but would pay $25 on the next $100 of income. Whatever the conversion amount, a couple just below this level of taxable income runs the risk that much of the converted amount is taxed at the next bracket. A taxable $60K, and the best this couple can do is to convert just enough to “top off” their 15% bracket. If they went a bit over, they can use perfect hindsight to recharacterize the exact amount that put them over, ending the year at the ideal $70,700 taxable. This process takes very little effort. Look at your 2011 return, and plan the conversion to just go over the bracket change. As you do your taxes next April, you recharacterize to nail the number dead on.
The market drops. Badly. In 2008, the market (as measured by the S&P 500, it’s what I track) dropped 37%. On January 2 2008, You converted $40K from your traditional IRA to a Roth. A year goes by, and the $40K has dropped in value to $25,200. To add insult to injury, you see the resulting tax bill – $10,000. Let’s not mix issues, for this example, you were already in the 25% bracket and weren’t expecting to pay less. But the market wasn’t supposed to tank and you were expecting at least the $40K you converted to be there after the year. There’s nothing to be done about the decrease in value, except maybe a bit of time and patience, but you could have recharacterized the $25,200, and avoid that tax bill. If you do this, you cannot convert again in the same year as the original conversion or within 30 days after recharacterizing. Not that big a deal. In 2009 wait 30 days and convert to Roth again, new tax hit? $6300. Congratulations, you just saved $3700 if you followed this math. But – The 401(k) custodian will usually not take back the funds to recharacterize that conversion. All is not lost, the IRS rules permit you to recharacterize from the Roth to an IRA, so in the end, there’s no actual risk with the direct conversion, only the risk of lack of knowledge on the process.
To wrap it up, I see no benefit in the direct conversion, and two major risks. If someone has any thoughts to the contrary, I’d love to hear from you.