The Roth Segregation Conversion Strategy

The other day in my post on Marotta Asset Management’s posts on Free Money Finance I mentioned a maneuver that could make a person some money that involves converting from traditional to Roth IRAs. It’s a fairly obscure strategy.  Google and I were only able to find one other explanation of it, in 1040 an article in the Journal of Retirement Planning from 2007. (See page 57.)

So Marotta may deserve credit for introducing this trick to the blogosphere.  Of course, last week I said that I thought that Marotta didn’t explain it very well.  It seems only sporting that I try explaining it myself.  In case it needs to be made clear, I am neither a CPA nor a lawyer, just a sneaky jerk who likes to do things that make him feel clever.

First, a few preliminaries.  Traditional IRAs can be converted into Roth IRAs, but a person has to pay tax on the balance that was in the traditional on the day of conversion as if it was income earned in that year.  Currently there is an eligibility limit based on income to be allowed to convert, but that limit goes away in 2010.

A person who has converted a traditional to a Roth has the right to "recharacterize", or undo, that conversion any time before the taxes are due.  So, if you convert your IRA in January 2010, you can change your mind and call it off on April 15, 2011.  (Or even later if you file for an extension.)

You are allowed to convert a single traditional IRA into several Roth accounts and can decide to recharacterize some, all, or none of them.

The trick is that being able to recharacterize is what we finance types call a free option.  The Roth isn’t a done deal until you file your tax return the following year, so when you convert all you are really doing is giving yourself the option to make that conversion permanent in the future by paying the taxes on today’s IRA balance.

This means that if a Roth account has gone down in value between the day of of conversion and when the taxes are due, you can undo it and keep from paying taxes on the now smaller account.  So if the account was worth $100K when you converted, but has since declined to $75K, you can call off the conversion to avoid paying taxes on $100K.  You can then wait a short period and convert all over again. On the flip side, if the account went up to $125K, you can keep the Roth and pay taxes on only $100K.

Recharacterization is a nice benefit of the conversion rules and one that many people who went from traditional  to Roth just before the stock market took a dive in 2008 took advantage of in April of 2009.

But the recharacterization rules are also something that can be exploited to turn a tidy profit if you set your mind to it.  For illustration, let me give an absurdly extreme example.

Suppose Pete the Plunger has a traditional IRA with $370,000 in it.  He converts that to 37 Roth IRAs, each with $10,000.  He then visits his favorite high-stakes casino where he bets the entire balance of each Roth on a different number on a single spin of a roulette wheel.  (Yes, I know this isn’t a legal use of an IRA. It’s an example. Chill out.) Black 19 comes up, bringing the balance of Roth IRA #19 to $360,000.  All the other Roths are, sadly, wiped out.  Pete later recharacterizes all those losers back to traditional.  Come next April, he pays taxes only on the $10,000 that went into #19, which is a great improvement over paying taxes on the entire $370,000 if he had simply converted his traditional IRA to a Roth in the normal way.

Pretty cool, huh?  The problem with executing this strategy in real life is finding investments, or a set of investments, that are legal for an IRA and that behave like a roulette game.  Ideally, you would want some collection of investments that behaved such that after a year or so, although you had about the same amount of money overall, one of those investments would likely have vastly outperformed the others. In the most ideal situation, it would be winner-take-all.

I’m having trouble coming up with investments that behave that way. My first impulse is to use a long position in a volatile stock in one account and a counterbalancing short position in the same stock in another, but as far as I know, no broker will allow an IRA to short stock.  Or write options.  I understand that there are places you can set up "self directed" IRAs that will allow trading in futures, but this is far from a simple undertaking.

Within the realm of ordinary stocks and bonds, the best I can come up with is a pair of long and short ETFs, such as the S&P 500 Spyder (SPY) matched with the ProShares Short S&P 500 fund (SH).  If anybody has any better ideas, please leave them in the comments.

Of course, a scheme using a paired ETF means only two Roth accounts and the result is unlikely to be that one account has all the money at the end of the year.  If the accounts start out 50/50 and wind up 70/30, you can recharacterize the 30, but you are only saving taxes on the difference between the 50 you put into the winner and the 70 that is in there now.

Both Marotta and the author of the journal article mentioned above have in mind that you will simply segregate the investments you already have in your traditional IRA into separate Roths.  So if you have a bond fund, a mid cap growth fund, and an international fund, you will shift them into three different Roths and then recharacterize back anything that happens to go down.  While doing this will undoubtedly make you better off than simply converting the whole account in the obvious way, your potential profit is relatively modest.  Indeed, depending on how much money is involved, the savings may not justify the paperwork.

Then again, there is that incomparable feeling of being clever.  That’s worth something.

No Comments

  • By ObliviousInvestor, June 8, 2009 @ 8:55 am

    Just a reminder: if you use this strategy via a pair (or larger set) of investments for which the gain in one will be offset by a loss in another, then we need to include the opportunity cost of earnings had you invested the money in something else.

  • By My Journey, June 8, 2009 @ 9:23 am

    Your explanation is much better, but the whole process seems extremely advanced for the readers of FMF whose average Retirement balance is probably under $150K?

  • By Kevin M, June 8, 2009 @ 9:44 am

    Good illustration. My guess (as a CPA) as to why we haven’t seen or heard more about this is exactly what you discuss in the fifth to last paragraph – finding investments that would be volatile enough to behave like your roulette example. If someone actually does this and is successful, we may hear about it – otherwise it’s just a scheme.

  • By GPR, June 8, 2009 @ 1:41 pm

    “Then again, there is that incomparable feeling of being clever. That’s worth something.”

    Absolutely. But you may have to offset this gain with the fact that your investment professional now hates the sight of you.

  • By IndependentOperator, June 8, 2009 @ 7:44 pm

    Brilliant. Thanks for sharing, Frank.

  • By Jim, June 9, 2009 @ 3:42 pm

    You can’t short stock in an IRA, but you can buy a deep in-the-money put. It’s not quite as efficient as shorting, but under most situations would serve your purpose.

  • By Frank Curmudgeon, June 9, 2009 @ 6:57 pm

    Well that gets the big forehead slap from me. Of course you can buy a pair of in the money options, one a call and one a put, and hope for some volatility. It’s not that cheap, and you are making a bet on volatility, but it’s probably the best we’ve got so far. If it worked quickly enough, you could have 4, 8, or even 16 Roths and run a tournament. Start with 8 accounts owning calls, 8 puts, allow one set to wiped out, repeat using the winners 4 vs. 4, and so on. With luck you might wind up with only one IRA that’s got most of your money inside the 18 months or so you have to pull this off. This could work.

    Anybody else got any ideas? Anybody else care?

  • By Josh, June 29, 2009 @ 5:47 pm

    Use binary options, e.g. BVZ or BSZ.

  • By RightSaidFred, July 1, 2010 @ 9:36 am

    Freakin’ brilliant strategy, Frank.

    Binary options would be perfect for this. It’s not quite as good as a Roulette wheel in that it’s a 1:2 bet instead of 1:36, so you’d have to carve your IRA into multiple small pieces and run a series of purchases/sales to finally produce a single winning account, but it would get the job done.

    Unfortunately, the spreads on those binary options are killer. I checked the CBOE quote page for them this morning, and the bid/ask on a BSZ call one month out is 0.48/0.77. OUCH! A spread that enormous kills all tax advantages.

    But there might be a way around this. I don’t know a whole lot about the business of market making and setting bid/ask spreads, so I’m just not certain. So my question is this: Taking the above example of a thinly traded option priced at 0.48/0.77, what happens if I simultaneously, in two separate accounts, issue a buy and a sell order on that option, each priced at a limit of say 0.64? Will the trade be made at 0.64 between my two accounts? Will it fail to go through because the market maker’s B/A spread overrides my actual limit order? Or is there some other likely outcome which would be detrimental to me (e.g., one side of my order being executed and the other not?)

  • By John, August 22, 2010 @ 4:05 pm

    You can easily do this w/ puts. Most IRA’s allow cash covered puts, so you buy an OTM put in one account and write the same instrument in the other. Commissions and the bid-ask spread will cost you some, but they’ll come close to exactly offsetting each other.

  • By Steve, September 19, 2010 @ 7:58 pm

    You could also do a bull or bear put spread.
    The trade can be sized to either double in value or lose everything and the other IRA could be set up to do just the opposite. You could do this on any option, including a heavily traded one where the bid/ask spread is small.

  • By pn, October 5, 2010 @ 3:52 pm

    Your description is not entirely accurate. You say:

    “If the accounts start out 50/50 and wind up 70/30, you can recharacterize the 30, but you are only saving taxes on the difference between the 50 you put into the winner and the 70 that is in there now.”

    The amount of tax “saved” in any year is fixed and is a function of the number of accounts that are winners/losers, not the amount of the winning/losing. For example, say you have $100 cash in your traditional IRA and assume it is all non-deductible. If you convert the IRA into a Roth, you would owe $35 in tax. Instead, you segregate the $100 into two $50 IRAs and convert. IRA 1 goes to $120 and IRA 2 drops to $30. You revoke the conversion on IRA 2. How much tax have you saved? Half your original tax bill. You will still owe $17.50 in tax on the conversion of IRA 1.

    If your two assets were perfectly offsetting (IRA 1 went to $100 and IRA 2 went to $0) then you would still have saved only $17.50 – you just wouldn’t have to repeat the strategy to get more of your traditional IRA funds into the Roth.

  • By Josh, February 28, 2011 @ 10:05 pm

    I’ve found an efficient solution to this (a bit late for the 2010 conversion special). Bizzarely enough, futures trading seems to be allowed in IRAs according to private letter ruling 8044023 and brokerages like Think or Swim support it. There is chance the conversion may fail if the market stays flat (I believe it is highly unlikely to do so for the ~22 month period). However, you avoid the ~10% loss on binary option spread.

  • By Tom, January 22, 2013 @ 9:52 am

    You can’t do both sides of a BSZ or BVZ option. The IRS doesn’t allow margin in IRA accounts, and there is no way to cover the write side of a binary option. In any case I haven’t found any brokerages that will even let you trade BSZ and BVZ in the first place in an IRA, not to mention the big bid/ask spreads previously discussed.

    However I have found several references online to the fact that you can create a “synthetic binary option” out of regular vanilla options. I just can’t figure out how to do this; I’m not sophisticated enough in options trading to figure it out. Can anyone refer me to somewhere that I can learn how to implement such a strategy?

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  1. Affine Financial Services » Blog Archive » IRA to Roth and back again. Wheeee! — June 21, 2009 @ 8:50 am

  2. Roth IRA, Retirement, Taxes — June 24, 2009 @ 12:44 am

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