Roth IRA Conversions—An Aggressive Strategy

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ACCUMULATE WEALTH AND REDUCE TAXES



March 2001 (Updated January, 2002)

Roth IRA Conversions--An Aggressive Strategy

James Lange, CPA, Esq

James Lange Law Offices Pittsburgh, PA

Though the amounts, effective dates and the shape of future tax cuts are uncertain, it is likely that we will enjoy tax reductions in either 2001 and/or 2002 and beyond. It is also fairly safe to say that we don't know what the stock market is going to do. These uncertainties have broad implications for Roth IRA conversion strategies. IRA owners should be prepared to respond.

The key to what I consider the most favorable strategy is the ability to "unconvert" a Roth IRA conversion. Technically, the correct term is to "recharacterize" a Roth IRA conversion back to a traditional IRA.

For tax years 2000 and later, you are allowed to "unconvert" an earlier Roth IRA conversion. The deadline for "unconverting" a year 2000 conversion is the day you file your 2000 tax return, normally by April 15, 2001. However, if you file two valid extensions, you may extend the time to October 15, 2001.

If you make a Roth IRA conversion in 2001, you may "unconvert" any time up until October 15, 2002. You may not make a conversion, "unconvert" it and reconvert the same IRA money in the same year. Even if you straddle different years, you must still wait the required 30 days before reconverting a Roth IRA that you had previously converted and "unconverted."

How do we profit from these rules or by looking at it another way, is there a legal loophole that can save IRA owners money?

Example 1: No Roth IRA conversion made in the year 2000:

Joe as three IRAs in mutual funds for $100,000 each. To simplify, please assume his IRA mutual funds represent three asset classes: large cap stocks, bonds, and international. For this example, Joe could also have three separate stocks and the concept would be the same. Any conversions or unconversions will be done through separate accounts. Though there is uncertainty as to exactly how much and when, let's assume Joe would benefit from a $100,000 Roth conversion.

Let's assume using a crystal ball we know that by October, 15, 2002 (due date of the 2001 return plus two extensions) the following occurs: tax rates go down for 2001, the value of the stock fund and the bond fund are steady or down and international is way up.

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Roth IRA Conversions--An Aggressive Strategy

Joe's options include:

1. Action: Make a $100,000 conversion now (early 2001) of any one of the asset classes and hope for an increase in the investment and lowered income tax rates.

Result: Would not be terribly advantageous to convert. Joe may maintain the Roth IRA. Alternatively either in 2001 or up to October 15, 2002, Joe may "unconvert." This may be beneficial in the long run. There is, however, no short-term larceny of the IRS's coffers or short-term improvement in financial position. The only way this strategy is a winner is if Joe picks the international to convert.

2. Action: Make a $100,000 conversion now (early 2001) for one-third of each of the three asset classes and hope for an increase in the investment and lowered income tax rates.

Result: This strategy will get the desired conversion result. This strategy will produce no windfall from investment returns, but will be a safer bet by spreading the money around. Joe may still "unconvert" the large cap and bond funds if it is warranted by tax rates or investments returns.

3. Action: Don't make any Roth IRA conversion waiting to be sure tax rates will be lower before making any conversion.

Result: A do nothing strategy does nothing. Perhaps it would be advantageous to consider a Roth IRA conversion in the future.

4. Action: Thread the Loophole Strategy: Convert all three to Roth IRAs and be primed to "unconvert" when necessary.

Result: In light of the tax changes and market trends, Joe "unconverts" the mutual funds that hold stocks, he "unconverts" the bonds and maintains the Roth IRA status of his appreciated international mutual fund. Joe has reaped an initial windfall of tax-free growth in the international Roth IRA fund.

He will still have to pay income tax on the $100,000 income for tax year 2001(for the international fund conversion). However, it will be at a lower tax rate and the value of his Roth IRA will be high. Then, within the same family of funds, so there are no transaction fees, he rebalances his portfolio. The result is that he now has an appreciated Roth IRA that he achieved by paying a low tax rate.

If the future worked out differently, Joe would respond differently:

1. If the tax rates stayed steady in 2001 and dropped in 2002, 2003 and 2004 and none of the mutual funds did very well in 2001, Joe would simply "unconvert" everything and be in the same position as if he had never converted.

2. If a different asset class Roth IRA mutual fund went up, Joe would maintain that asset class and "unconvert" the other mutual fund Roth IRAs.

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Roth IRA Conversions--An Aggressive Strategy

Of course, most clients will feel uncomfortable with the "Thread the Loophole" approach. There could be mechanical failures. The IRA owner might forget to "unconvert" and that could present a financial disaster. In addition, the IRA owner might die. (Though Roth IRAs are perhaps even more favorable for estates than IRAs.)

But for some intrepid IRA owners, the "Thread the Loophole" strategy will have a certain appeal! It would also be reasonable to develop a personalized approach using some of the thread the loophole principles.

Reservations aside, the strategic advice is: when in doubt, make a partial Roth IRA conversion and if necessary, "unconvert" in the future.

Example 2: Taxpayers who made a Roth IRA conversion in 2000

Assume that earlier in the year 2000, you converted a traditional IRA for $100,000 to a Roth IRA. Since the time of the conversion, the stock value has plummeted to $80,000. With this scenario you are stuck paying income tax on $100,000 for a Roth IRA currently worth $80,000. Consider "unconverting" which would put you in a position similar to where you would have been if you had not made the conversion in the first place. That is, you would have a traditional IRA with a value of $80,000 and no resulting tax liability from the conversion.

Then come the beginning of 2001, or thirty-one days after the "unconversion" (which ever comes later), you have the option to reconvert that same money (now in a traditional IRA) back into a Roth IRA. You would then be liable for income taxes on $80,000, not $100,000. In addition, you would be liable for the taxes on the conversion for tax year 2001, not year 2000.

Another idea for taxpayers who like to "Thread the Loophole" is to continue to wait and see. Since you have until October 15, 2001 to "unconvert," you could file one or even two extensions on your U.S. Form 1040, buy more time, and wait and see. You could even convert a different IRA to a Roth IRA in 2001, and in October 2001, decide which of the two Roth IRAs you want to keep.

Another idea for taxpayers who like to "Thread the Loophole" is to continue to wait and see. You have until April 15, 2002 to "unconvert," and you can request an automatic four month extension to file your US 1040. This buys more time, until August 15, to wait and see. It may be possible to obtain an additional two months of time, through October 15, by filing a second extension request, although you must have good reason to do so. The second extension is not automatic, neither is it automatic that the request for a second extension, to October 15, will be approved. The second extension requires a valid reason for undue hardship (i.e., you should not request a second extension for convenience, and/or not for the specific purpose of "waiting to see how the Roth IRA conversion performs"). Furthermore, you could even convert a different IRA to a Roth IRA in 2002 and in August or October 2003 decide which of the two Roth IRAs you want to keep. It is critical to remember that you must file for the extensions before the returns are due. The second extension should be requested within sufficient time for the IRS to respond with an approval before August 15 so if the second extension is denied, the unconversion can occur by the August 15 due date.

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Roth IRA Conversions--An Aggressive Strategy

The result of this Roth IRA maneuvering could be a lower tax liability and a greater amount of assets growing income tax free in a Roth IRA.

Time Line

2002 Any time during the year, preferably early, consider a conversion strategy that could include Roth IRA conversions of three different stocks or asset classes.

12/31 Last chance for additional Roth conversions for 2002.

2003

Any time during the year, preferably early, consider a conversion strategy that could include Roth IRA conversions of three different stocks or asset classes.

4/15 File first extension for your 2002 tax return if you want more time to consider your year 2002 conversion. Remember, extensions are not automatic, and Form 4868 must be filed by April 15.

7/15 File second extension request for taxes due on 2002 tax return if you have a valid need for more time to prepare your return. We recommend filing it a month early, July 15, to allow time for the IRS to respond. This can also give you more time to reflect on your year 2002 conversion. Remember, this second extension is not automatic.

10/15 Final deadline for "unconverting" your 2002 Roth conversion with a valid second extension received.

11/16 Now allowed to "reconvert" the IRA funds unconverted from the Roth on 10/15/2003. Actual date will be a month after the unconversion date.

12/31 Last chance for additional Roth conversions for 2003.

This time line does not project beyond 2003, but barring other tax law changes the same logic would continue to apply for future years.

Most clients will not have the interest or the time to engage in some of the complicated maneuvering brought up in this article. But, for clients or planners who do take the time to properly implement the suggested strategy, there are great rewards.

The advice in this newsletter should only be undertaken with full understanding of the risks and under the direction of a qualified advisor.

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Law Offices of James Lange

2200 Murray Avenue Pittsburgh, PA 15217 412 521-2732 - 800-387-1129 412-521-2285 FAX admin@rothira-

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