Multiple Roth IRA Conversion Strategy

Many investors are aware of the benefits of a Roth conversion. Essentially, any time an investor owns a tax-deferred account, the government gives him the right to change it at any time to a tax-free Roth IRA. The only price to pay is the taxes due on that money. Thus, for most investors, there are times in life when it is more advantageous to do a Roth IRA conversion than others. Before examining those times, and discussing a less well-known strategy for doing these, let’s consider the benefits of a Roth IRA conversion.

4 Benefits of a Roth IRA Conversion

The main benefit of a Roth conversion is that the investor’s tax-free to tax-deferred ratio increases. This allows for lower future tax bills. This is especially advantageous when the taxes can be paid at a lower rate now than they can in the future. That higher future tax rate may occur due to either personal financial issues, or dramatic changes in the tax code. If nothing else, more tax-free money provides valuable flexibility and tax diversification in retirement.

A second benefit is an advantage that Roth IRAs (but not Roth 401(k)s) have over traditional IRAs—there are no Required Minimum Distributions (RMDs) on Roth IRAs. Thus, a Roth conversion allows you to leave your money in a tax-protected account for a longer period of time, and thus have more to spend or pass on to heirs.

A third advantage of a Roth IRA conversion is that it allows you to essentially move money from a taxable account accessible to your creditors to a tax-protected account not available to your creditors (in most states.) For example, instead of $30,000 in a traditional IRA and $10,000 in a taxable account, after the conversion you may have $30,000 in the Roth IRA.

Finally, a Roth IRA conversion reduces the size of your estate and may keep your estate size under the federal, or more likely, a lower state estate tax exemption limit.

The Seasons of Your Life and Roth Conversions

The idea behind a Roth conversion is that you want to do them when your taxable income is relatively low compared to your peak earnings years. Residency and especially the year you leave residency are relatively attractive times. If you cut back to part-time for any reason, or go on a sabbatical, that is also a good year for a Roth conversion. Perhaps the most popular time for Roth IRA conversions is after retirement but prior to receiving Social Security benefits.

Multiple Roth IRA Conversions

A little-known technique for doing Roth conversions involves taking advantage of the government’s offer to re-characterize your Roth IRA conversions. If you decide that a conversion was a mistake, you can reverse it until October 15th of the following year. That allows you a period of 9-21 months to change your mind. The IRS does not, however, require you to have a good reason. You can do it for whatever reason you like, including if it is financially advantageous to do so. This is the essence of the multiple IRA conversions strategy.

If your goal were to do a $20,000 Roth conversion, but you wanted to make sure it was as financially advantageous as possible, you may wish to split your IRA into multiple $20,000 IRAs. Perhaps 2, 3, 4, or even more. Convert ALL of them to a Roth IRA and invest each IRA into a different asset class. Perhaps one into US Stocks, one into international stocks, one into bonds, and one into real estate. The asset class that performs the best is left as the “true” Roth conversion, while you re-characterize the rest. For example, if your marginal tax rate is 25% and the US stock market did poorly and dropped 40% while bonds went up 10%, converting the “bond IRA” instead of the “stock IRA” means you get $22,000 in the Roth IRA for your $5,000 in taxes instead of $12,000 for that same $5,000 tax bill.

This strategy obviously involves significant hassle, and may not be worth the time and effort for smaller conversions, but the larger the conversion, the more benefit to the strategy. There are 2 more re-characterization rules to be aware of. If you later decide to reconvert an IRA you re-characterized, you must wait 30 days, or until the first of the year after the conversion, whichever is longer. Also, if you do your re-characterization after filing your taxes, you must file an amended tax return. These rules are important to be aware of, but relatively easy to work around. For example, if you wait until October of the following year to re-characterize, you only have to wait 30 days to initiate a new conversion. You can even delay filing your taxes until October by filing for an extension.

Roth IRA conversions are likely to make sense for you at some point in your life. This multiple IRA conversion strategy can help you to eke out even more benefit from doing them.

Dr. Dahle is not an accountant, attorney, insurance agent, or financial advisor. He blogs as The White Coat Investor and is the author of the best-selling The White Coat Investor: A Doctor’s Guide to Personal Finance and Investing.