What may be an optimal time to convert a traditional IRA to a Roth IRA has arrived. Beginning in 2010, high-income taxpayers qualify to make the switch, and for some, the basic trade-off of a conversion—paying income tax now in return for tax-free income during retirement—could be worthwhile. As an added incentive, taxes on conversions made in 2010 can be paid during the following two years. Yet with markets unsettled, a conversion could backfire, leaving you to pay income taxes on assets that have lost value after the transfer to a Roth. Establishing multiple Roth IRAs, rather than just one, could give you the flexibility to minimize the damage.  By splitting up a converted Roth, you avoid having to make an all-or-nothing choice about whether to “recharacterize” the account back into a traditional IRA. The IRS gives you that option, allowing you to undo a conversion and avoid the associated taxes. But you can’t do a partial recharacterization, returning only selected assets to the traditional account.
That’s the benefit of establishing multiple Roths. You might use one account for stocks, for example, and a second for non-stock investments such as bonds. Then, when it’s time to file your tax return for the year of the conversion, you can look at the investment performance of each account. If stocks have fallen while bonds were positive, you might decide to recharacterize the stock Roth IRA but leave the other alone. In fact, rather than just creating two Roth accounts, you can go even further with this technique, subdividing the “stock” account by industry sectors or capitalization.
The old rule for conversions, which required an adjusted gross income of $100,000 or less, is eliminated in 2010. But those who choose to convert a traditional IRA to a Roth IRA will still owe income tax on the converted amount that’s attributable to tax-deductible contributions and earnings. (Non-deductible contributions are exempt.) That tax is particularly painful if the value of account investments has fallen sharply, and many account owners who converted early in 2008 undid the conversion after the stock market plummeted later in the year. You have until your tax return due date, plus extensions, to change things back to the way they were.
By splitting your assets into separate accounts, you can wait to see how each account performs. The earlier in the year you make the conversion, the longer you’ll have to make a final decision. For example, if the conversion took place on January 1, 2010, you have until April 15, 2011, to decide about a recharacterization—or until October 15, 2011, if you elect an extension. What if you determine that future investment performance will improve for that asset class you just recharacterized? You can “reconvert” your traditional IRA to a Roth, but not until the start of the following year or 30 days after the recharacterization, whichever comes later. |