Structuring the Roth Conversion

In a recent article, I briefly covered the topic of Recharacterization.  The example that I gave was pretty simplistic – you converted an amount, and decided later to recharacterize that amount back to an IRA.  What if it gets complicated?


There are some steps you can take in your conversion that will help you to recharacterize later, if the occasion should arise.  These steps to structure the conversion are by no means required, they’d fit into a “simplifying your life” category, more than anything – or what I have heard referred to as a CYA* activity.


Structuring a Conversion

If you think you’ll want to come back and consider recharacterizing some of your conversion, you should start off with a brand-new Roth IRA account as the receiver of the conversion.  This way you don’t have to worry about separating the money later on during the recharacterization (if that comes about).


In addition, depending upon the volatility of your holdings, you might want to chunk things up even further – especially if we’re dealing with a sizeable amount of money.  You might consider chunking your account into Large-caps, small-caps, and global stocks, at the very least.  There’s no limit on the number of funds you could split the holdings into, so if you wanted, you could open a new Roth account for each asset that you own.


The point to all of this splitting is that, in the event that one of the assets dramatically reduces in value through the year, since you’ve kept them segregated, it will be simple to recharacterize just that one asset. This way you can keep from paying higher tax on a dramatically reduced asset.


But wait!  Doesn’t the IRS treat all IRAs as one account?  Hold on, there – before you get all dressed up and jump off a chair: You’re making the assumption that there is consistency in the rules… and consistency in the rules would be a huge departure from the IRS’ proud, nearly 150-year track record.  Besides, if the rules were consistent and made sense, then what would guys like me write about?


In the case of recharacterizing funds converted to a Roth IRA, the IRS only considers the account you converted into.  This is why it’s important to (at the very least) start with a fresh new account – because any recharacterization in an account that included prior conversions and/or contributions will likely dilute the effect of the recharacterization.  At the very least, commingling conversion funds will really complicate things, and lead to some potentially uncomfortable moments during the audit.


The more you’ve chunked your account, the easier it will be to choose only those funds that have fallen in value to recharacterize.  Otherwise the benefit is diluted by any increases on other holdings.


* Not really sure, but I think CYA in this sense stands for “Chunk Your Accounts”. You may have a different interpretation.

About the author

Jim Blankenship, CFP®, EA

Jim Blankenship is the founder and principal of Blankenship Financial Planning, Ltd., a financial planning firm providing hourly, as-needed financial planning and advice. A financial services professional for over 25 years, Jim is a CFP professional and has earned the Enrolled Agent designation, a designation that qualifies him as enrolled to practice before the IRS. Jim is also a NAPFA-registered financial advisor, which designates him as a Fee-Only Financial Advisor.

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3 Comments

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  • Hi, Conor –

    On your first question regarding the tax on your conversion – the tax on a Roth conversion is based upon the year you enact the conversion. The exception is in 2010, when you can elect to have the entire conversion taxed at the 2010 rate or half at the 2011 rate and the other half at the 2012 rate. If you convert your IRA to a Roth in 2009, the tax on the conversion will be based on your income and the conversion amount in 2009.

    Your second question about the mechanics of the conversion is pretty straightforward – open the Roth IRA account (either at your current IRA custodian or a new custodian, it’s your choice). Once the Roth account is established, put the paperwork in place to do a trustee-to-trustee transfer between the traditional IRA and the Roth IRA – making sure that it is clear to the custodian(s) that this transfer is a Roth conversion. This is necessary because the transaction will be reported as a distribution, and so it must be classified correctly. Then when you file your taxes, you’ll also need to fill out Form 8606 (Part II) to indicate the conversion. You probably want to get this going ASAP if you want it done in 2009 – especially if you’re going to a new custodian!

    Hope this covers your questions! If you run into issues don’t hesitate to contact me.

    jb

  • Hi Jim,

    I am currently a grad student who has a rollover IRA from a previous employer and am looking to take advantage of my very low tax rate for 2009 and roll over my IRA to my Roth IRA. I do expect my future tax rates to be much higher in the future. I don’t plan on taking the money out of the Roth until I retire, but I want to confirm that if I rollover the IRA this year in 2009, that the tax I pay will be based on my 2009 income level tax (which as a grad student is pretty low) and not on my tax rate from when I was employed and contributing to my 401k. I plan on paying the tax due from my savings account so I’ll keep the full amount in my IRA when I transfer it to a Roth IRA. My follow-up question is , how do I actually do the conversion. Is this something I can do through my brokerage account or do I simply close out my IRA, transfer it to my Roth IRA, and then fill out the appropriate tax form come tax season?

    Much Thanks and great articles!

    Conor

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