A smarter strategy for recharacterizing Roths

Despite the substantial tax benefits that come with Roth IRAs, there are many reasons why a client might want to undo a conversion and transfer funds into a traditional IRA.

If your client's Roth IRA performed poorly since it was converted, it might not be worth the tax liability, which is imposed upon the total value converted even if that value decreased following the conversion. For example, if a client in the 35 percent tax bracket converted $100,000 into a Roth IRA in 2013, and the account depreciated in value to $70,000 (though this would represent quite a decrease), the client will owe taxes on the $100,000 that was converted, regardless of the fact that the account is now worth much less. The client would likely benefit from recharacterizing the Roth IRA and moving the funds back into a traditional IRA to avoid the tax hit.

A client who has unexpectedly jumped into a higher tax bracket may want to recharacterize a Roth conversion because keeping the conversion would mean that he must pay the taxes on the account value at a higher than anticipated rate. Further, clients who had unexpected expenses during the year and simply cannot afford to make the tax payment can also recharacterize the funds and defer the tax liability to a later date.

Conclusion

It is important that each client gain professional advice in establishing multiple Roth accounts, paying special attention to the cost of establishing these accounts relative to the amounts converted. However, for clients looking to make substantial Roth conversions and take full advantage of the possibility of recharacterization, a multiple Roth strategy can provide maximum value.

For previous coverage of Roth conversion strategies in Advisor's Journal, see 401(k) vs. IRA: The Real Roth Conversion Question.

For in-depth analysis of Roth IRAs generally, see Advisor's Main Library: Roth IRAs.

Your questions and comments are always welcome. Please contact the Panel of Experts.