Today, I’d like to discuss an approach that may seem a bit out of the norm. Don’t let that scare you off, there are some lesser known strategies that are perfectly legal, they simply take advantage of the tax rules as they are written. Let me slide into this slowly.
I wrote about the Roth IRA Conversion in which we discussed the process of converting some or all of your Traditional IRA to a Roth, and the tax implications that follow.
Next, we talked about The Roth IRA Recharacterization, the “do over,” which allows you to reverse the process on any or all of that conversion.
This process of Convert/Recharacterize offers an interesting opportunity for those with time and patience. You have the ability to convert IRA assets into more than one Roth account. If your IRA is well diversified, you’re likely to have some amount of cash and some stocks or stock funds. You can convert $10,000 in cash, for example, and $10,000 worth of a stock fund into two separate Roth IRAs. Skip ahead, a year later, but before your final return for the year of conversion. The stock fund dropped 20%, so instead of paying tax on $10,000, you recharacterize just that fund, and you have $8000 you can try to convert again in the next tax year or after 30 days. You leave the cash alone at it’s grown to $10,002 and you have some room before hitting the next bracket. If the stock fund shot up, and is worth say, $12,000, you still owe the tax on just the $10,000 value you converted, but now have $12,000 value in the Roth.
With me so far? Good. Now, let’s take it up a few notches. Instead of just two Roth accounts, there’s nothing stopping you from filling out the forms to open up 5 or even 10 Roth accounts. It’s just a matter of time and patience from both you and your broker. If you look at the returns of different asset classes over the years, you find that different sectors outperform the market while others lag. By using this process, you can boost the amount of money you’re transferring to Roth at no additional cost. The best performing asset may have performed so well that even if the conversion pushes you to a higher bracket, that cost is well worth it.
I’d still caution, don’t lose sight of what your assets will be at retirement. You still have your exemption ($3800 each, for you and a spouse if filing joint) and a standard deduction ($5,950 if single, or $11,900, married filing joint) which add to a decent number you can withdraw tax free. Then, a 10% bracket and 15% bracket. For this reason, one should be careful not to get too aggressive on the conversions, but maintain a balance between Traditional and Roth. If a Roth is in your future, the Roth Roulette strategy may save you a nice chunk of change over time.