[Update 5/2018- Roth IRA recharacterizations were outlawed starting in 2018, so the “horse race” technique discussed in this post is no longer permitted.]
When discussing Roth conversions of pre-tax money, it is important to distinguish it from two other commonly used techniques. First, a Roth conversion has nothing to do with a Backdoor Roth IRA, the mechanics of which are discussed here. Nor does a Roth conversion have anything to do with the decision of whether to use the tax-deferred or tax-free (Roth) option in your 401(k) (or for low earners, choosing between a Roth IRA and traditional IRA.)
A Roth conversion is taking money that has never been taxed, usually out of a traditional IRA, and moving it to a Roth IRA and essentially “pre-paying” the tax. As a general rule, paying your taxes any earlier than necessary is a bad move, but for those doing Roth conversions, the benefits are thought to outweigh the downsides. That is usually because the Roth conversion can be done at the same or lower tax rate than the money will be pulled out at decades later. Aside from the main benefit of allowing you to pay less overall taxes, there are a couple of side benefits of a Roth conversion. First, if you're someone with a Required Minimum Distribution problem (may we all be so lucky) Roth IRAs don't have RMDs. Second, you generally pay for a conversion with taxable money, so in effect a Roth conversion allows you to move money from taxable space into tax-protected (and in most states, asset-protected) space.
The best times to do Roth conversions are in those years when you're in a lower tax bracket than your peak earnings years. For a typical doctor, this might be medical school (if you had a prior career at which you contributed to a tax-deferred retirement account), residency (especially the year you leave if there wasn't a Roth 401(k) or 403(b) option at your residency program), sabbaticals, after cutting back to part-time, and particularly those years between retirement and when you start collecting Social Security or a pension.
Sometimes people do a Roth conversion and then regret it. In these situations, the IRS allows you to reverse it, as though it never happened. This is called a recharacterization and can be done until October 15th of the following year. So if you did a Roth conversion on January 2nd, 2017, you have until October 15th, 2018 to reverse it. A lot can happen in the 22 months between January of one year and October of the next year. Ideally, whatever the asset you invested those Roth IRA dollars in went through the roof. Sometimes, however, the value of that asset drops dramatically. For example, consider a $20,000 Roth conversion that cost you $5,000 in taxes. What if a big bear market came along and the value of that $20,000 asset dropped to $5,000. Now you've paid $5,000 in taxes just to convert $5,000. Doesn't seem so smart, does it. Might be a good idea to recharacterize and try again next year. This is the same reason people suggest doing Roth conversions during bear markets- it costs you less to transfer the same number of shares from a traditional IRA to a Roth IRA.
The Horse Race
This recharacterization rule is what allows for the relatively advanced “Horse Race” technique. Let's say that you decide in January that you want to do a $20,000 Roth conversion this year. But rather than just converting $20,000, you convert $40,000, while planning to recharacterize $20,000 22 months later. Which $20,000 will you recharacterize? The one that did the worst. If one grew to $30,000 and the other grew to $25,000 (or worse, fell to $10,000) you would recharacterize the loser. No harm done as long as it is an asset you would have been holding somewhere in your portfolio anyway. The idea behind the horse race is to increase your ratio of tax-free to tax-deferred holdings without any additional tax cost for doing so.
In fact there is no reason there has to only be two horses in the race. You could enter three, four, five, or even a dozen horses. The only limitation is how much complexity you want to deal with. Each horse should be an asset class you are otherwise comfortable owning, but which has as low of correlation as possible with the other horses. So perhaps you use a total stock market index fund for one horse and a total bond market index fund. If you want more horses, perhaps an emerging markets fund, a small value fund, a REIT fund, a long term treasury fund, a money market fund, a precious metals fund or all kinds of other options. Volatility is not necessarily a bad thing. You're hoping one of these horses really has a great year, and that's the one that you actually keep. If your $20,000 conversion grows to $30,000, but you only paid $5,000 in taxes, you've gotten a really good deal.
Some have even considered going more extreme- using options, futures, or shorting stocks in order to have more of a binary outcome between the two horses. However, IRS and broker limitations on what is and isn't allowed in IRAs severely limit your options here, not to mention the additional complexity and costs. You are probably better off with more vanilla holdings.
The How-To Guide
- Decide if a Roth conversion actually makes sense for you to do this year. The earlier, the better.
- Decide how much you wish to convert. Tough to do at the beginning of the year before you can project your income and deductions well, but the earlier the better. The general rule is to convert up to the top of the 15%, 25%, or 28% bracket, but that's a lot easier to do in December than in January.
- Open multiple Roth IRAs.
- Transfer money from the traditional IRA to each of the Roth IRAs in the amount of the desired conversion.
- Invest each Roth IRA in a different asset class, adjusting the remainder of your portfolio to ensure your desired asset allocation is maintained.
- File an extension for your tax return (not mandatory, but probably a good idea.)
- Next October, recharacterize all the losing Roth IRAs.
Obviously, if you do this every year with multiple asset classes, you're going to have a bunch of Roth IRAs around, since you will have started the year two horse race before the year one horse race is over. Only you can decide how much complexity is worth the tax savings you may see.
Two Other Options
You have two other options besides simply declaring the winner of the horse race. You can declare everybody losers (if all the assets fall in value) and recharacterize all of the Roth IRAs or declare everybody winners (assuming it is worth the additional tax cost to you) and not recharacterize any of the Roth IRAs.
A Roth IRA conversion horse race is an advanced technique that most probably won't bother with due to the hassle factor, but for a large conversion, it can make a lot of sense for someone not afraid of some hassle in order to optimize their situation.
What do you think? Have you done a Roth conversion? Have you done a horse race? How did it turn out? Comment below!