The recent bout of market volatility, and any resulting drop in clients' individual-retirement-account values, should prompt advisers to take another look at
Roth conversions.
Performing a Roth conversion is a way for investors to turn traditional, or pre-tax, IRA money into
Roth IRA money by paying tax on the money now rather than later.
It's a tax strategy that is
especially advantageous in down markets, based on the idea that investors will ultimately pay less in taxes today than in the future due to asset values being depressed.
However, due to the
past month's market volatility, advisers should be considering a “re-characterization,” or undoing, of clients' Roth conversions, which essentially converts the Roth money back to pre-tax money.
“Whenever you see a big swing in the market like this, it's a perfect opportunity to revisit prior Roth conversions,” according to Tim Steffen, director of
financial planning within Robert W.
Baird & Co.'s private wealth management group.
A re-characterization, which could be on all or a portion of pre-tax IRA assets, would be appropriate for any investor whose IRA account value has dropped post-Roth conversion. The point would be to undo the conversion, and then redo it when the holdings are (hopefully) lower-priced in the future, Mr. Steffen said.
“The value is really following up [the re-characterization] with another conversion, and another conversion that allows you to do the same [IRA] assets at a lower cost or more [IRA] assets at the same cost,” Mr. Steffen said.
The S&P 500 index
was down around 5% in January, and is down 6% overall since the start of the year. The index has declined 7.5% since last August, when there was another bout of volatility that led to a 5% dip that month.
“For individuals who made Roth conversions in 2015, there's the distinct possibility the values have declined since then, and it's an opportune time to revisit and take advantage of the re-characterization opportunity,” said Suzanne Shier, chief wealth planning and tax strategist at
Northern Trust.
However, there are some nuances advisers should consider before undoing a Roth conversion.
TIMING
Investors have until Oct. 15 of the calendar year following that of the Roth conversion to undo the conversion. In other words, if the Roth conversion took place in 2015, the deadline would be this October; if the conversion occurred this year, investors have until October 2017 to re-characterize.
However, there are rules around when investors can go ahead and re-convert back to a Roth account. The re-conversion can only take place after the latter of two time periods: the calendar year following the original Roth conversion, or more than 30 days after re-characterizing the original Roth conversion.
For example, the calendar-year rule would prevail if both the conversion and re-characterization take place early in the same calendar year. So, if a conversion took place in January this year and was re-characterized shortly thereafter, investors would wait until Jan. 1, 2017, to re-convert.
The 30-day rule would be the operative rule if the Roth conversion had occurred in March 2015, and an investor then decides to re-characterize the conversion in February 2016. In that case, the investor would have to wait more than 30 days, or until March 2016, to complete another Roth conversion with that money.
For those who have done a Roth conversion since the beginning of 2016, Jeffrey Levine, chief retirement strategist at Ed Slott & Co., recommends investors wait until around mid-November this year to decide to re-characterize, given these timing rules.
That's because an investor would only have to wait until January 2017 to re-convert the account to Roth, thereby limiting the time in which the market could rebound and erase any potential benefit. If that same investor were to re-characterize at this point in the year, he would be exposed to market movements for a longer stretch of time.
“The market could increase and you could end up kicking yourself in the pants,” Mr. Levine said.
PRO RATA RULE
Advisers also need to pay attention to the “pro rata rule” when doing Roth conversions, according to Mr. Steffen. That basically makes the tax benefit more difficult to calculate if converting money from a traditional IRA to an existing Roth IRA.
That's because the aggregate value of the assets in the existing Roth IRA, not just the ones being converted to Roth, need to be assessed. (For example, if an investor wants to convert Stock A to Roth because its value fell, but the value of Stock B, which is in the existing Roth account, rose at the same time, it could offset the benefit of converting Stock A.)
So, Mr. Steffen recommends doing all conversions into brand-new Roth accounts to avoid the pro rata rule. Then, once the Oct. 15 deadline for re-characterization has passed, investors can combine the accounts.
AMENDED RETURN
For those who file their 2015 tax return by April 15, and then decide to perform a re-characterization after that date and before the Oct. 15 deadline, an amended tax return must be filed to reflect the re-characterization.
Or, if a re-characterization is something investors would seriously consider between April and October, they could get an extension for filing the tax return until October to avoid having to file an amended return at all, according to Ms. Shier.
However, the tax on the conversion still comes due in April. Investors would get that tax money back, though, if they ultimately decide to re-characterize by October.
