Advantage of Early Roth Conversion

Longer life for the "option"

By Kaye A. Thomas
Posted January 7, 2008


This may be the best time of year.

In November and December we see lots of articles on year-end tax planning. For some reason, there's a tendency to ignore tax planning opportunities that provide special advantages early in the year. This is the ideal time of year to convert a traditional IRA to a Roth.

Background

This topic is covered in Chapter 18 of our book, Go Roth!

A Roth conversion can boost your ability to build and preserve retirement wealth, but the results are not always favorable. The tax you pay on the conversion is based on the value of the account at the time of the transaction. If the account performs well afterward, that's great because you've avoided paying tax on this boost in value. When the account produces losses after the conversion, though, a tax based on the earlier value is a disadvantage.

Fortunately there's a way to get out of this bad result: you can use a recharacterization to undo the conversion. (Guidance on recharacterizations can be found in Go Roth!, our book on Roth accounts, or in our free online Guide to the Roth IRA.) Basically this involves moving the money (as adjusted for investment performance) back to a traditional IRA. After a required waiting period you can do a new conversion at the lower level. As a general rule you can undo a conversion any time until October 15 of the year following the year of the conversion.

Technically the deadline is April 15, but you can get an automatic six-month extension of this deadline to October 15 unless you fail to file an income tax return or extension request by April 15.

Why convert now?

Your ability to undo a Roth conversion places you in a position similar to someone owning a stock option during the period from the date of the conversion until October 15 of the following year. If your investments go up in value, you "exercise" the option by leaving the conversion in place, achieving the favorable result of avoiding tax on this increase in value. On the other hand, if your investments decline in value, you don't have to "exercise" the option. You can undo the conversion, avoiding the bad result of paying tax based on the higher value that no longer exists.

Like any other option, this opportunity has value to you that depends on the length of time until the option expires. If you do a Roth conversion in December, you'll retain your ability to back out of the transaction through only about 10 months of market performance. A conversion in January gives you an option that lasts more than twice as long.

Ideally, you would want to do your conversion at the time when the market is at its low point for the year, which won't necessarily be in January. The problem is that we can't know in advance when the low point is going to occur. If we had a way to predict market performance reliably, we wouldn't need the recharacterization option in the first place. Lacking the ability to determine in advance when the market will hit its low point, we should consider doing the next best thing, which is to maximize the length of this "option" by doing Roth conversions early in the year.

Another advantage

There's another reason to favor a conversion early in the year. Tax on the conversion is due April 15 of the following year. (Depending on your situation, you may have to make estimated tax payments sooner.) A conversion early in the year gives you more than a year to be gaining the benefits of the conversion through investment growth in your account before you have to pay the tax. If you convert later in the year, there's less time lag between the date you begin building tax-free investment returns and the date you pay tax on the conversion.

Roth conversions aren't for everyone, and I certainly don't mean to suggest that people rush into a conversion without proper analysis. If you're in a situation where a Roth conversion makes sense, though, this is the ideal time of year to consider the move.


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