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.

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