Disallowed recharacterization
Suppose an IRA owner were to convert his IRA into two Roth IRAs. In Roth “A”, he were to place an even money bet on a coin toss covering heads, while in account “B” he were to place an even money bet on the same coin toss covering tails. After the coin toss, one or the other account would win, doubling to the total value of the original IRA while the other would lose. The losing Roth account could then be recharacterized to recover the tax liability, effectively reducing the tax cost by 50%.
Since we can’t invest in coin tosses, a similar result may be derived from the use of options.
However, could the IRS claim that the transaction might be disallowed under economic benefit doctrine, since it would take a large movement in the underlying securities to generate a positive return? Or is the chance of a significant return sufficient to defend against this arguement?
I look forward to your thoughts!
Permalink Submitted by Alan Spross on Tue, 2009-11-10 18:56
The IRS has never challenged the ability to do multiple Roth conversions in a single year, and then to selectively recharacterize the losing conversions and retain the winners. Different Roth accounts would have to be used for this strategy to work.
The use of options in an IRA account may be limited by the IRA custodian.
Permalink Submitted by [email protected] on Tue, 2009-11-17 21:17
Seems to me you don’t need options. You coud use ETFs. You could put the S&P spider SPY (or any of it’s copycats) in one account and an inverse S&P ETF in the other…. No….?
Seems to be lots of ways to emulate a coin toss in the market these days…
Permalink Submitted by Bruce Steiner on Wed, 2009-11-18 02:53
Larry: did you come to one of my talks on Roth conversions? The example I used was to go to Las Vegas and invest one on a bet on the NFC champion in the Super Bowl and the other on a bet on the AFC champion in the same Super Bowl. You’d get slightly less than even money since the house has to cover its expenses and make a profit. I warned the audience that I didn’t think that would work because the two investments (bets) were interdependent, and that there was no opportunity to make a profit but for taxes (indeed, but for taxes, you’d be guaranteed a small loss).
But many people have said that they think you can create separate Roth IRAs for different asset classes.
No one knows where the boundary is. I think the best analogies are to the wash sale rules, and to the requirement for a profit motive in being able to deduct investment losses.
This post, like all posts in a discussion group such as this, are not intended as legal advice. For specific legal advice, you should consult with your own counsel.
Permalink Submitted by Larry Kriesmer on Wed, 2009-12-02 16:47
[quote=”[email protected]“]Seems to me you don’t need options. You coud use ETFs. You could put the S&P spider SPY (or any of it’s copycats) in one account and an inverse S&P ETF in the other…. No….?
Seems to be lots of ways to emulate a coin toss in the market these days…[/quote]
In my opinion, I think you need a strategy that will respond quickly (with much volatility). If you deploy this “coin toss” strategy and extend it over a year or more, with one asset gaining at approximately the same rate the other loses, you’ll generate the tax savings but lose out on the investment performance. For example, if the SPY is up 25% and the SH loses 25% over a year, you’ve generated some tax savings on the loser, but lost out on the 25% gain at the portfolio level since the sum of your investments is essentially the same as your starting amount.
Using options, you can accelerate the gain/loss and then deploy the winning proceeds into a traditional investment model while sending the loser back to the IRA’s traditional investment model to wait for the next opportunity to convert. Ideally, you want one Roth to lose nearly 100% of it’s value, while the other doubles, and you can’t exepct that to happen in the SPY/SH combo. Unless you think the SPY could get to 220 plus over the next year and a half. With a properly structured call/put combination, you might achieve that coin toss objective in a very short time.
Of course, the market has to MOVE in order for any of this to work… so that’s the soft spot.
Permalink Submitted by Larry Kriesmer on Wed, 2009-12-02 16:57
[quote=”[email protected]“]…. I warned the audience that I didn’t think that would work because the two investments (bets) were interdependent, and that there was no opportunity to make a profit but for taxes (indeed, but for taxes, you’d be guaranteed a small loss). No one knows where the boundary is. I think the best analogies are to the wash sale rules, and to the requirement for a profit motive in being able to deduct investment losses.[/quote]
No, I didn’t attend one of your talks. I was at the IRA Success in Scottsdale in November this year. Our investment firm uses options extensively for our portfolios so the option idea came to me as a result. I agree that the coin toss would likely be challenged since there is no profit potential other than the tax savings.
However, in a properly structured option strategy, there is potential for significant gain if the market move is sufficiently large. Unlike the even money coin toss, where the payoff is 100% with a loss of 100% resulting in a net wash, the option strategy could generate a multiple of 100% on the winner, with losses limited to 100% on the loser. This would result in an overall profit on the two transactions rather than a wash. Since there is a potential of profit, well in excess of the “safe” rate of return, does anyone have an opinion on the service’s abilty to challenge the transaction on economic benefit doctrine?