You’ve read all about Roth IRA conversions, and you know a lot about the questions that one must resolve in order to make one of these conversions work out for you. Have you considered how the valuation rules will impact your decision process?
Valuation of your IRA
If you have IRAs that contain both pre-tax and post-tax contributions and you’re looking to take a distribution (such as for a Roth Conversion), you know that you have to look at all IRAs in aggregate in order to determine what amount of the distribution is taxable and how much is tax-free. But when do you determine the valuation of the account?
It’s kinda tricky – and probably not what you were thinking. Your IRA balances are determined as of the end of the tax year in which the distribution occurs – so if you make your distribution in 2010, the balance as of 12/31/2010 is what is used to determine your IRA balances. This amount will include any amount that has been distributed to you, either in the form of a cash payout, or as a conversion to a Roth IRA.
For example, if you had two IRAs, one that is completely taxable (all deductible contributions and growth), totaling $20,000, and the other is made up of $10,000 in non-deductible contributions and $10,000 in growth and other deductible contributions. The total value as of December 31 of these two accounts is $40,000, with $10,000 being non-deductible or after-tax contributions. So any distribution you made during the tax year from either of these IRAs would be 25% tax free (since 25% of the accounts is after-tax).
Simple Enough, Right?
Well, maybe not. The problem with the valuation method comes in when you consider what happens over the course of the year – especially if you’ve made a distribution early in the year.
How about if you had the accounts mentioned above in the example, except that the values were as of January 15, rather than December 31. You enact the conversion at that time… and then time goes on, and your investments perform as they might throughout the year. Then on December 31 your IRAs are now worth a total of $50,000 – and your non-taxable portion is still only $10,000. Since this has occurred, now only 20% of your conversion will be tax-free, which may make a difference in your computations. In this case you have the comfort of knowing that your original conversion amount may have grown in value (assuming similar growth in all accounts), so the new growth since the conversion will receive tax-free Roth treatment.
And what if, after the conversion your accounts reduce in value? From our example, as of December 31 the accounts are now worth a total of $30,000. This means that a higher percentage of your conversion distribution was non-taxed, a total of 1/3 at this point. This might be to your advantage (less tax paid) but it also might mean that you’re paying tax on an amount greater than the value of your accounts – especially if your account(s) downturn continues. In a case like that, you have until October 15 of the following year to recharacterize the conversion in order to not have the tax bill on the lower amount. (You can learn more about recharacterization in the article “Help Mr. Wizard – I didn’t wanna do a Roth Conversion!”)
So as you can see, the timing of your conversion versus the timing of the valuation of your IRA accounts can have a large impact on the way your Roth Conversion plays out for you. Consider this information wisely as you plan your conversion strategy…