October 31, 2009. By now, most people have heard about Roth conversions and how useful they are. You get to take money from an existing IRA or qualified plan, convert all or part of it to a Roth IRA, pay the tax, and you create a nice tax-free accumulation vehicle. Some obvious rules apply: for example, I don’t think you should convert unless you are either staying in the same tax bracket, or will be in a higher tax bracket later. I am also certain that Roth conversions are most effective if you use non-Roth money (outside monies) to pay the taxes.
But that’s not what I want to talk about now. I want to talk about Mulligans. I used to run marathons, wore out my ball joint (hip) and had to quit running. So, I took up golf. I could spend hours ranting and raving about my golf game, but since I was introduced to the Mulligan the game is a little less frustrating. Apparently a French Canadian named David Mulligan hit a poor shot in his game and set down another ball and hit again. He called it a ‘correction shot’, but his foursome dubbed the do-over a ‘Mulligan’. I like having the Mulligan option: I hit a bad shot and get to do it over. In fact, I maintain that if I had unlimited Mulligan use, I might shoot some decent golf.
So what does this have to do with Roth conversions you might ask? Most of us understand the basic concept of converting an IRA into a Roth IRA, however, a lot of us don’t necessarily know about the ‘un-do’ option of a Roth conversion through what is called a ’recharacterization’. Recharacterization is reversing the Roth conversion. Why is this important? Say you convert an IRA worth $100,000. The market goes down, and now the account is worth $80,000. You can recharacterize the Roth back to a regular IRA, and not pay the taxes (or get a refund if you paid the taxes). What’s more is that you can then re-convert the IRA back to a Roth. In other words, you get a do-over, or a Mulligan.
Just as in golf there are rules, of course. You can only recharacterize a Roth conversion account once (one Mulligan per round), and then only up to the due date of your tax return, including extensions (provided you filed a timely return). This timeline is irrespective of when you file your return. So if you converted to a Roth in 2009, you have until October 15, 2010 to recharacterize. If you convert in 2010, you have until October 15, 2011. If you recharacterize, then re-convert, you pay taxes on the conversion in the year you convert. So if you converted an IRA to a Roth in 2009, then recharacterized in 2010, then re-converted, you’d pay the tax in 2010, or under special rules, pay the tax in 2011 and 2012. Also, once you recharacterize a Roth, you may not re-convert it for 30 days.
As I mentioned earlier, I want more than one Mulligan. (If you play golf like I do, you want to take as many Mulligans as you need.) With Roth conversions, you can have multiple looks at a do-over. Here’s how. The rules on recharacterization are at the account level. This means you can have multiple Roth conversion accounts, and can selectively recharacterize those conversions. By segregating Roth conversion IRAs, each holding different investments you may selectively re-characterize. Suppose you have a $100,000 IRA consisting of $50,000 of AAPL stock and $50,000 of F stock. Suppose further the AAPL goes down to $35,000 and the F goes up to $60,000. If you convert both securities into one Roth, you may only recharacterize the entire account, your tax savings would only be on $5,000 (the original $100,000 conversion, less the $95,000 recharacterization). But suppose you made two Roth conversions into separate accounts, maybe a day apart, one holding AAPL and one holding F? The AAPL Roth could be recharacterized, and the F Roth could be left alone, you are then saving ordinary income tax on $15,000. After 30 days, you could re-convert the AAPL Roth.
Under this segregation plan, if one Roth goes up, you simply leave it alone. If one goes down, you can recharacterize that Roth, and possibly re-convert it at the lower value. This could be taken to the extreme by creating many Roth conversion accounts, encompassing multiple assets classes (a Roth containing Large Cap domestic stocks, another holding Emerging Markets or commodities) but the general idea is to allow flexibility for recharacterizations – numerous Mulligan opportunities. After the recharacterization date has passed, you may want to blend the Roth accounts together to simplify for record keeping purposes. Also recognize that recharacterization and re-converting re-starts the five-year holding period for the Roth conversion IRA.
Of course, like in golf, I really DO NOT want to use a Mulligan: I’d rather have a good round without any bad shots. But in today’s volatile financial world, and lots of Roth conversions on the horizon, segregating Roth accounts is an interesting plan. It is a wee bit complicated, but could be a valuable strategy as you prepare to convert in 2010. Multiple do-over shots: David Mulligan would approve.