Roth-Conversion-Cost Averaging: A Smart Tax Strategy in Turbulent Markets

By Jeffrey Levine, Dir. of Retirement Education
Follow Me on Twitter: @IRAGuru4EdSlott

The Roth IRA is one of the most useful tools in the retirement planning bag of tricks. But just as the quality of any tools at your local hardware store might vary from shelf to shelf, so too do the qualities of Roth IRA conversions you might execute.

In the most basic Roth IRA conversion, you would move money from an IRA or other eligible retirement account to a single Roth IRA. The amount moved (converted) would generally be added to your income for the year, and you would pay that tax bill when you filed your tax return for the year (if not sooner). You might look to see whether a recharacterization – a fancy tax word for “undo” – would make sense before the following October 15, but you really wouldn’t pay much attention to the conversion itself after that, other than, perhaps, managing the investments in your Roth IRA to achieve a favorable outcome.

There’s nothing wrong, per se, with a “plain vanilla” conversion like the one I’ve just described, but there are many ways in which you can improve the efficiency of your Roth IRA conversions. Such strategies include converting early in the year (giving you the most time possible to evaluate your conversion), converting to multiple accounts (allowing you to cherry-pick winning and losing accounts) and converting only enough so as not to exceed a particular tax bracket.

Another Roth IRA conversion strategy that is discussed with much less frequency is what I call Roth-conversion-cost averaging. The name, as you might suspect, comes from the similarities it shares with an investment purchasing strategy known as dollar-cost averaging. Roth-conversion-cost averaging can – depending upon how far you want to take it – require a fair amount of extra work, but it’s also a strategy that can pay significant dividends, especially in times when markets are volatile. And in case you’ve been living under a rock since the ball dropped in Times Square on New Year’s Eve, now just happens to be one of those times.

Quite simply, Roth-conversion-cost averaging is a strategy whereby you plan to convert – or at least consider converting – at regular intervals in an effort to attempt to execute your conversion as close to “the bottom” as possible. Each time you make a new conversion, it should be made to a brand new Roth IRA account, enabling you to cleanly cherry-pick the account with the most capital appreciation before the recharacterization deadline.

Here’s an example of how this strategy might work in practice:

Suppose Adam has $300,000 in his traditional IRA and believes that $25,000 is the optimal amount he should convert to a Roth IRA this year for tax efficiency. Although it would rarely be the case, for the sake of simplicity, let’s assume that Adam only has one investment within his retirement account, Stock X, valued at $10 per share.

In January 2016, Adam converts 2,500 shares of Stock X, worth $25,000, from his traditional IRA to a Roth IRA. He now has $25,000 in a Roth IRA and $275,000 in a traditional IRA.

By April 2016, however, Stock X’s price has dropped 10%. The shares are now valued at $9 each, leaving Adam with $22,500 in his Roth IRA and $247,500 in his traditional IRA. Now you might say to yourself, “Who cares? It’s only April 2016 and I don’t have to decide whether or not to keep this conversion until October of 2017!”

Well, there’s certainly some truth to that, and if you want to go the plain vanilla route, there’s nothing inherently wrong with sitting back and seeing how your conversion performs over the next year+ before making any permanent decisions. But there’s probably a better course of action. Why doesn’t Adam convert another $25,000 of Stock X from his traditional IRA to a Roth IRA with the idea going in that he will definitely recharacterize his first conversion?

Let’s see why this makes sense. To begin with, when Adam makes his second conversion, he will be able to convert roughly 2,778 shares of Stock X instead of the 2,500 he initially converted. There’s certainly no guarantee, but if Stock X subsequently rebounds – which is often the case – Adam’s second conversion will appreciate at an accelerated rate compared to his initial conversion.

Now let’s fast forward to July 2016 when Adam is once again evaluating his Roth conversions. This time, the price of Stock X has remained stable at $9 per share. Here’s where the comparison to dollar-cost-averaging departs a little. With dollar-cost-averaging, you buy more of an investment at regular intervals regardless of whether the investment is up or down. Here, however, since the shares of Stock X have not declined below the lowest “conversion point,” there’s no need to make another conversion at that time.

Imagine, however, that come October 2016, the price of Stock X has dropped to $7 per share. Now, because the value of the Stock X is lower than the previous low conversion point, it once again pays to execute another $25,000 Roth IRA conversion. This time Adam can convert nearly 3,600 shares of the Stock X. Adam would plan to recharacterize at least his first two conversions, while evaluating this third one more thoroughly as the recharacterization deadline approaches.

At some point, Stock X is likely to find a bottom, and when it does, Adam’s Roth-conversion-cost averaging approach will have allowed him to make his conversion closer to that bottom. With any luck, Stock X’s rebound will be strong, and as a result of using this strategy, more of that growth will occur with Adam’s Roth IRA tax free.

So is this extra work worth it for you? That’s a decision that only you – perhaps with the input of a tax and/or financial advisor – can make for yourself, but it’s certainly something worth considering. After all, if you’re going to fork over a heap of taxes to Uncle Sam before you have to, shouldn’t you get as much out of it as possible? I, for one, say yes.