Conversion/Recharacterization Sanity Check
I’m contemplating re characterizing a ROTH conversion and and starting the conversion process over and would appreciate a sanity check on my planned process.
In Feb 2011 I converted $115k now worth about $109k. I plan to convert another $115k before 2011 year end. Then at end of first quarter 2012 just before filing taxes I will re characterize whichever account has the lowest value back into the [u]original[/u] TIRA account.
My primary objectives are to not open unnecessary accounts (due to next year/30 day rule), not miss out on a 2011 conversion as I’m trying to do partial conversions each year up to about age 70. I’m now 63. I know I have until October 2012 to do the re characterization, but I would take the long view and assume by the time of withdrawals the account will have gains instead of losses.
Does this plan make sense?
Permalink Submitted by Alan Spross on Mon, 2011-12-05 22:59
A 6% loss is fairly small to recharacterize when the markets are gaining or losing up to 15% in any given month. However, if you are willing to complete the transactions and reporting necessary, there is nothing wrong with your plan. If the investments were the same in both conversions, a new conversion done now will be worth 6% more than the old one for an indefinite period of time. What this does NOT mean, however, is that the new one won’t be farther underwater next October than your current one will be in March. That is, unless you invest the new conversion in stable value instruments probably yielding next to nothing. That would insure that when the recharacterization deadline arrives you will have a conversion that is not underwater at all.
You might invest the new conversion conservatively per the above and let the first one ride or even ratchet up the risk in the initial conversion. It might more than make up that 6% deficit and be far ahead of your new conversion by next Sept, and if so you would recharacterize the second conversion in Sept and keep the largest gainer.
If you are going to recharacterize anyway, may as well utilize the entire allowable time period unless there is no hope for the present conversion. With only a 6% loss, there is plenty of time for that conversion to recover and move into positive territory.
Don’t worry about the reconversion time constraints because you can prove to the IRS that you did the second conversion before you recharacterized the first one.
What messes up all this analysis is when you make large changes in investments in the Roth after the recharacterization deadline because that deadline means very little over a 20 year period. If you removed all temptation to lose both conversions to recharacterization by being ultra conservative in the new conversion, but changed the investments after October and the market tanked, you probably would not feel very good about the tax bill you had paid.
Of course, if you delay your recharacterizations beyond March, you would probably extend your return rather than filing it, and just file once by October.
So your plan does make sense if you would rather just complete the tax process in April and pass on the extra 6 months of potential investment results differences between two different conversions. The 6% gain you are starting with would grow to an additional 12,000 tax free after 12 years assuming a 6% annual return.
Permalink Submitted by Dave Haynie on Tue, 2011-12-06 17:08
Thanks for your extended rationale of doing vs. not doing what I proposed as it helps me in figuring out and explain what I want to accomplish. I’ve been somewhat agonizing (exaggeration) over this subject.
My situation is such that, disregarding black swan events, the ROTH will probably pass on to heirs in 20-30 years. I have created a spread sheet that allows me to project the estimated tax bracket when beginning RMD’s. I’ve determined that if I do the largest conversions before starting SS and then gradually reduce the conversion amount after that I can get my RMD’s low enough to keep my taxable income now and later at the low end of the 25% tax bracket if not lower. Obviously it depends on rate of returns achieved as well.
Until 2011 my plan was ROTH’s be 100% equities and TIRA would be a mix of equities and bonds expecting long term performance, >>10 years, of equities would be better than a mix of equities and bonds. However, I’m now thinking (but I’ve not made a final decision) that for the time period of April to October of the year following conversion maybe short to intermediate term bonds (I’d take more risk than stable value) would be the way to go even if the only reason would be to avoid the emotional disappointment of paying a higher percent in taxes on the current value if lower or loosing a years conversion to re coup the taxes. Either way after the re characterization deadline I would revert to all equities in the ROTH.
Yes, if I follow through with what I proposed one conversion will be all bonds and the other conversion will be all equities until I decide to make the re characterization.
One idea you suggested that I hadn’t considered is letting both conversions go to October 2012. It just occurs to me that if I could pay the tax owed on one conversion (not two conversions) in April, file for an extension to file in October then re convert the lower value ROTH just before the later filing deadline. [u]Or would I have to pay the tax in April on both conversions and then get a refund when I file in October?[/u]
Thanks for your advice and discussion, Dave
Permalink Submitted by Alan Spross on Tue, 2011-12-06 17:36
Dave,
Sounds like you have it well thought out. You would only have to pay the tax on one conversion in April to avoid an underpayment or late payment penalty, but when you file in October be sure to include an explanatory statement for the recharacterized conversion showing the date and amount of the conversion, that 100% was recharacterized and how much transferred back to the TIRA. You would probably want to recharacterize around the end of Sept to have time to complete the filing on time with all the info.
Permalink Submitted by Dave Haynie on Tue, 2011-12-06 17:56
Thanks Alan, that latest option really simplifies the decision process.