IRA Monte Carlo Revisited: Undo Traditional IRA to Roth IRA Conversions

My post yesterday about the varying performance of different asset classes reminded me about a Businessweek article called the IRA Monte Carlo. This is a tax-saving trick for those who wish to convert their Traditional IRAs or old 401ks to Roth IRAs. Here’s a snippet:

1. Let’s say an investor has one traditional IRA with a value of $4 million.

2. The traditional IRA is split up into four traditional IRAs, each worth $1 million.

3. The investor converts all four to Roth IRAs at the beginning of the year.

4. The IRS effectively allows taxpayers to undo the conversion for up to 21 months. So in 21 months the investor looks at the performance of the IRAs. Say two of them go up from $1 million to $2 million and two drop from $1 million to zero. Because the IRAs were split into four, the investor can change her mind on the two that went down and revert those back to traditional IRAs. Thus, she owes taxes on only the two contributions that went up in value, and nothing on the two that went down, cutting her tax bill in half. This lops 21 months of risk off the bet that paying taxes now will be paid off with tax-free appreciation later.

Did that make sense? It was a little confusing for me, so here’s my take on it. Right now, there is no income limit converting Traditional IRAs to Roth IRAs (and paying the taxes owed). Everyone can do it. Basically, in the conversion you pay taxes now on gains at your current tax rate, but then as a Roth IRA your future gains are tax-free. This works out to be a good idea if your future tax rates upon withdrawal end up higher than your tax rates right now.

It boils down to: Pay your taxes now? or pay taxes in the future?

Let’s say you agree your future tax rate will be higher, whether for personal reasons (you think future income will be higher or at least the same) or external reasons (you think Uncle Sam will raise tax rates). The loophole here is that you are allowed an “undo” by the IRS, which you can take advantage of by splitting your big traditional IRA into multiple, smaller, separate traditional IRAs. Then convert the smaller IRAs, and wait up to 21 months:

  • If the value of the converted IRA goes down, then you can undo the conversion and then redo it later, saving you on taxes. For example, if you converted $100,000 in Emerging Markets stocks in the beginning of the year and it went down to $80,000 – would you rather pay taxes on $100k or $80k?
  • If the value of the converted IRA went up – say from $100k to $115k if you invested in Treasury bonds throughout 2011 – then you’re happy because that $15k gain is all tax-free. You just sit back, sip your cocktail, and leave it alone.

There’s not many times in life you get to hit the “undo” button. As in the examples given, I would recommend putting different asset classes in your separate IRAs so that you can take advantage of any non-correlated performance. Don’t completely change your investment holdings just for this tax trick, though. Just putting stocks in one and bonds in the other can offer a potential benefit.

Comments

  1. I’m thinking of doing this since my IRA has gone down from when I did a conversion earlier this year. My question is what happens to the tax withholding that I had done (I think it was 10%)? Does that just get added back in to whatever my current balance is?

  2. Great post. Another option is to recharacterize the gaining IRA’s. Taking your second bullet point example where you have a roth @ $115k. You could recharacterize the original $100k back to a traditional IRA and owe no taxes on anything. No taxes on the gain ever, and no taxes on the $100k until the next recharacterization (or withdrawal). Rinse and repeat each cycle.

  3. @ Jason

    Typically any withholding you had taken out with the conversion is going to be considered a distribution (and likely an early distribution subject to 10% penalty on top of income tax). Unless you’re within the “60 Rollover” period, you won’t be able to simply put that back into your account.

    Regardless of whether you “re-characterize” the prior conversion, if you had tax withheld on the conversion out of the traditional IRA you generally will owe income tax and the 10% on early withdrawals if you are younger than 59 1/2.

    It sounds like you may need to talk to your tax advisor regarding your specific situation in case there are any mitigating factors with your situation.

  4. One clarification on my comment above, the amount of withholding will be considered a distribution and potentially subject to tax/penalty and not the full conversion amount. Sorry I didn’t make that clear originally.

    Example: $100,000 Traditional IRA converted to a ROTH IRA
    $10,000 withheld in federal taxes
    $90,000 actually put into the Roth IRA

    Regardless of what you do with the $90,000 (or whatever the balance in the Roth is currently), the $10,000 likely will be subject to the 10% early withdrawal penalty if younger than 59 1/2 because you probably won’t be able to put it “back” into the account if you choose to re-characterize. Your custodian/broker has probably already sent it to the IRS.

    Sorry for the length and if I caused any further confusion.

  5. I thought about doing this earlier this year during the market drop in sept or oct
    From my discussions with fidelity it would take up to 10 days to complete the recharacterization. I decided to hold off, and during the next 7 days the market rallied >10%. I didn’t get the recharacterization off the ground but due to the extreme volatility, it would not have done me any good anyway.
    Is there a faster way to do the process?

  6. @Enonymous

    The rechar should take all of 5 mins. I did it this year w/ Vanguard on October 17th via phone.

  7. @ William
    Thanks for the response. But damn, I shouldn’t have had the withholding done then. I had no idea that I would get hit with the 10% early penalty by doing so. Principal advisor did not inform me of that. Guess I’ll have to leave it as is then.

  8. @dan

    weird – Fidlity indicated that yes the forms would take only a ew minutes but it would take a certain number of business days for the recharacterization to ‘take effect’

    I’m glad I didn’t do it since the 5+ business days it could have taken/might have taken would have basically wiped out the whole point of doing it – volatility can be frustrating!

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