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IRA to Roth and back again. Wheeee!
One of the most interesting posts I’ve read recently is Frank Curmudgeon’s* The Roth Segregation Conversion Strategy.
Before we launch into Frank’s strategy, let’s cover the basics.
Recharacterization is the ability to move money that you put into your Roth IRA this year, into a traditional IRA instead. It was created to enable people to correct their mistakes, such as funding a Roth IRA when their adjusted gross income is too high. Recharacterization enables correction without penalty.
The basic Roth recharacterization tax-avoidance strategy goes like this:
- At the beginning of the year, you convert your IRA into Roth,
- At the end of the year, you recharacterize the Roth back into the IRA,
- If the Roth earns money during the year, you only have to recharacterize the amount put in at the beginning of the year, leaving the earnings in the Roth forever tax-free.
- If the Roth loses money, you only have to move back remaining amount into the IRA. And you can try again next year
Mr. Curmudgeon takes it one step further,
- At the beginning of the year, you take your IRA, and divide it into two halves.
- Invest one half long and one half short (e.g. S&P 500 ETF’s), each in a Roth IRA.
- At the end of the year, one investment will be up x%, and the other will be down x%.
- Then you recharacterize both back into IRA’s.
- For the Roth that made money, you need only recharacterize the amount you originally put in, letting you leave the x% in the Roth, forever tax free.
Sounds like a great idea. I can see why he enjoyed working in a hedge fund. If you start with $200k, the market moves 10% in a year, and you’re in the 28% tax bracket, you’ll save $2800 in income tax, less transaction costs. That’s only a 1.4% return on your investment, but it is risk-free.
Towards the end of his post, Frank gets cranked-up and starts optimizing the strategy through winner-take-all strategies. You can minimize taxes by dividing your IRA investment into 37 Roths and (somehow) bet each on a different number on one spin of a roulette wheel. One Roth will win, and it ends up with roughly 37 times its original amount, tax free. All the other Roths are worthless. The net result is to transfer the original sum into a Roth, tax free. There’s the little problem that roulette bets are not a legitimate IRA investment option, but a reader proposed an option, if you’re interested.
I thought this all sounded quite interesting but just a little too good to be true. Why would the IRS let me recharacterize only the original amount?
I began searching the IRS website. The original IRS Code 408A(d)(6)(B)(i), clearly states that if you recharacterize, you must include the earnings.
If so, that blows the whole scheme.
There are legitimate uses of recharacterization, but use them sparingly to avoid the unpleasant glower of the IRS. I think I’ll leave the roulette wheel to Frank.
* I love the nom de plume.
Image credit: Flickr
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I believe you have mis-interpreted the strategy. In the roulette example, you first create 37 traditional IRAs, then convert them to Roths, then make your bets, then before the tax year ends, you recharacterize the losers back to traditional IRAs.
You don’t recharacterize the account that grew and thus you only have to pay taxes on the amount that was there when you made the Roth conversion, before you won big.
As for the other accounts which lost out, you do recharacterize them and therefore do not pay any taxes on them, they started as traditional IRAs and they are once again traditional IRAs before you finalize your tax return. Furthermore, there are no earnings in the loser IRAs, in fact there will be less than the amount at the start left, so of course you don’t want to pay taxes on the conversion amount because you have lost big in those IRAs.
SomeGuy:
If you have losses, when you recharacterize, you can only move back the original amount minus your losses, thus you will still have to pay tax on the amount of the loss.
You’re right that I may be missing something — others have written similar comments as you — but when I read the code, I get a different story.
And, what are the chances, Jim at Get Your Financial Ducks in a Row just wrote a post about this too.
http://financialducksinarow.com/1812/structuring-the-roth-conversion-a-cya-activity/
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