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IRA Investment Planning for Taxation

Dec 15th, 2010
by jblankenship.
2 comments

The question often comes up – what types of investments are best for my IRA?

Of course, any investment that you make in a tax-deferred fashion is a good one, at least in theory.  But there are other investments that make the most sense for your IRA versus other vehicles… and some investments that make more sense in other kinds of investment accounts, where possible.

Listed below are a couple of considerations to take into account when considering taxation of your IRA and non-IRA investments.

Bonds and other interest-bearing vehicles

Given the nature of the IRA – deferring taxation on current income and growth, investments that would otherwise be taxed at ordinary income tax rates would be best for your IRA.

This includes the likes of interest-bearing investments, such as CDs or bonds.  Since, presumably, your tax rate when you begin taking distributions will be either the same or less than your rate before retirement, the deferral will provide for the interest to be taxed at either the same rate or lower, just later in your life.

Growth-oriented and dividend-paying investments

Growth-oriented stocks and investments that pay current dividends make more sense to be held in taxable accounts than in deferred accounts.  This is due to the fact that dividends and capital gains are (at least for now) taxed at much lower rates than ordinary income – which is the rate your distributions from the IRA will be taxed at.

The same would be true of other growth- and dividend-oriented investments such as real estate and commodities, for example.

Bottom Line

So in other words, if you have the ability, you should split your interest earning investments into your IRA, and growth- and dividend-oriented investments into taxable accounts.  This way, you won’t be subjecting lower-taxed items to a higher tax rate – if possible.

This doesn’t mean that you should ONLY invest in items that would be taxed at ordinary rates within your IRA.  This is known as letting the tax-tail wag the investment dog.  Tax planning should always be considered as you plan your investments, but appropriate diversification should always be your first consideration.

In addition, the deductibility of IRA (and 401(k)) contributions provides a benefit that should be weighed against the taxation concepts we’ve talked about above as well.  Again, the tax-tail shouldn’t wag the investment dog…

Photo by Wikimedia

Timeless Thoughts on Investing

Dec 13th, 2010
by jblankenship.
1 comment

800px-Timeless_BooksI was recently reading an older book, The Money Game, by “Adam Smith”, and I came across a very poignant passage that I thought I should share.  This book was written in 1967, and it is a very interesting view of money and how we view it.

The passage relates to how we view investments in general, as well as the importance of having a goal for your investments and saving activities.  Keep in mind that passage was written more than 40 years ago, so some references will be woefully out of date, but the message is still clear and valid.  Let me know if it gives you inspiration – I thought it was particularly good:

A stock is, for all practical purposes, a piece of paper that sits in a bank vault.  Most likely you will never see it.  It may or may not have an Intrinsic Value; what it is worth on any given day depends on the confluence of buyers and sellers that day.  The most important thing to realize is simplistic: The stock doesn’t know you own it. All those marvelous things, or those terrible things, that you feel about a stock, or a list of stocks, or an amount of money represented by a list of stocks, all of those things are unreciprocated by the stock or the group of stocks.  You can be in love if you want to, but that piece of paper doesn’t love you, and unreciprocated love can turn into masochism, narcissism, or, even worse, market losses and unreciprocated hate.

It may sound a little silly to have a reminder saying The Stock Doesn’t Know You Own It were it not for all the identity fuel provided by the market these days.  You could almost sell these identities as buttons:  I Am the Owner of IBM, My Stocks Are Up 80 Percent; Flying Tiger Has Been So Good to Me I love It; You All Laughed When I Bought Solitron and Look at Me Now.

Then there is a great big master button called I Am a Millionaire, or I Am So Shrewd My Portfolio Has Gone into Seven Figures.  The magic of this million-dollar number, and of its accessibility to Everyman, is so great that books sell with titles like How I Made A Million or You Can Make Millions, with very little content at all.  They are the most dangerous of all the things written on the market because (and I collect them as a hobby) inevitably there is some mechanical formula somewhere within.  Never mind who you are or what your capacities and abilities are, just charge in with the book open to chapter three.

If you know that the stock doesn’t know you own it, you are ahead of the game.  You are ahead because you can change your mind and your actions without regard to what you did or thought yesterday; you can, as Mister Johnson said, start out with no preconceived notions.  Every day is a new day, providing, in the Game, a new set of continuously measurable options.  You can live up to all those old market saws, you can cut your losses and let your profits run, and it doesn’t even make your scar tissue itch because, being selfless, you are unscarred.

It has been my fate to know people who have made considerable amounts of money, sometimes millions, in the market.  One is Harry, who made it and blew it and made it again.  Harry really wanted to make a million dollars, and he did.  I think Mr. Linheart Stearns had a very good point when he said the end object of investment ought to be serenity.  Now if you think making a million dollars will give you serenity, there are two things you can do.  One is to find a good head doctor and see if you can discover why you think a million dollars will give you this serenity.  This will involve lying on a couch, remembering dreams, talking about your mother, and paying forty dollars an hour.  If your course is successful, you will realize that you do not want a million dollars but something else which the million dollars represents to you, such as love, potency, mother, or what have you.  Released, you can go off about your business and not worry any more, and you will be poorer only by the number of hours you spent in accomplishing this times forty dollars.

The other thing you can do is to go ahead and make the million dollars and be serene.  Then you will have both a million dollars and serenity, and you do not have to deduct the number of hours times forty dollars unless you feel guilty about making it.

It seems simple, and there is indeed a catch.  What do you do if the million dollars arrives and serenity does not?  Aha, you say, you will worry about that when you get to it, you are shure you can handle it.  Perhaps you can.  Money, contrary to popular myth, does help people more than it spoils them, simply because it opens up more options.  The danger is that when you have your million, you then want two, because you have a button saying I Am A Millionaire and that is who you are, and there are, all of a sudden – as you will notice – so many people with buttons saying I Am a Double Millionaire.

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The trouble with Harry is not just the trouble with one man who made and lost a lot of money, nor even that there are hatching, at this very instant, other Harrys who will play out this role next month and next year.  The trouble goes beyond Harry, beyond Wall Street; it’s a kind of virus in the whole country, when the cards of identity say not how well the shoe is cobbled or the song is sung, but are a set of numbers from an adding machine.  Usually we hear only the triumphs by adding machine, but those who live by numbers can also perish by them, and it is a terrible thing to have an adding machine write an epitaph, either way.  Perhaps measuring men by the marketplace is one of the penalties of our age, but if some scholar would tell us why this must be, we would all know more about ourselves.

Boilt down, the gist of this passage is two lessons:

1) Don’t get emotionally involved in your stock, fund, or whatever investment you make.  All decisions should be made without regard to your past ownership or any other factors besides the fundamental and technical analysis you do on your investment choices.

2) Have a goal in mind for your investment activity.  What “Smith” recommends is simply serenity – and if you can define “serenity” for yourself, you’ve set the goal.  And if serenity isn’t what you’re looking for, choose and define “chaos” or whatever is important to you.

Photo by Wikimedia

Excerpt from The Money Game, by ‘Adam Smith’, pages 81-84

Wash Sale Rules and IRAs

Dec 8th, 2010
by jblankenship.
1 comment

laundry by mckaysavageYou may already be familiar with the Wash Sale Rule for buying and selling securities – briefly, if you sell a security at a loss, if you’ve purchased it within 30 days (either before or after the sale), then the loss is disallowed for tax purposes.

The rule is relatively clear, but what’s not clear to many folks is that this applies to all accounts that you and your spouse own – including IRAs.  How can capital losses be considered within IRAs, you may ask?

Well, here’s an example:  Say you purchased 100 shares of ABC stock in your taxable account at $50 per share several years ago.  After holding the shares for quite a while and watching them languish and continue to lose value, you decide to sell the shares at $40 so that you can at least take the tax loss for some minimal benefit from the situation.

Then, a week after you sell the shares, you learn that ABC is ready to introduce a brand-new, absolutely revolutionary, widget.  This new widget is expected to blow the industry away – and you want to get in on the action.  So, realizing that you just sold 100 shares for a loss, you have your spouse buy 100 shares in his IRA for $43, 8 days after you sold the original 100 shares.

Bingo.  You just triggered the wash sale rule, disallowing the original loss for tax purposes.  This is because in considering the wash sale, all accounts, IRA or not, for you and your spouse, are included.  Unfortunately in this case your tax loss is gone forever since your IRA purchase has no tax basis.

Had the accounts been reversed – that is, if the original purchase had been made in the IRA and the subsequent purchase made in the taxable account, you’d at least have your basis of $43 against which future capital gains or losses would be calculated.  Additionally, if you had only waited 30 days from the original sale of the shares of ABC, you could have made the purchase in either account with no wash sale impact.

So be careful as you make tax loss moves – consider all of the ramifications of the wash sale rules.

Photo by mckaysavage

Prohibited Transactions and Disqualified Persons

Dec 1st, 2010
by jblankenship.
4 comments

prohibited by Phillip McI have covered the topic of Prohibited Transactions in an earlier article – basically that you can’t self-deal with your IRA by borrowing from, selling to, or allowing a class of persons, called Disqualified Persons, to transact business with your IRA as well.

The problem that often comes up, especially with IRAs that invest in “self-directed” activities like Real Estate, is that folks look at the list of Disqualified Persons and determine that there are other persons that they can have making transactions with their IRA – and that since these others are not Disqualified, the transaction will no longer be a prohibited transaction.

Let’s back up and define Disqualified Persons – this means you, as the account owner, your spouse, your parents, grandparents or other ancestors, as well as your children, grandchildren, or other descendants, as well as the spouses of any of these persons.  So, for example, your step-child wouldn’t be a Disqualified Person, as long as you haven’t adopted the child.  In addition, your siblings aren’t Disqualified Persons either, nor would your girlfriend or boyfriend.  So technically, one of these people could transact business with your IRA – as long as there is no other reason to prohibit the transaction.

The problem is, if you (or another Disqualified Person) benefit directly or indirectly from a transaction with the IRA, the transaction is prohibited – no matter who the person is that you’ve transacted with.  So, for example, if you’ve invested in a condo with your IRA money, and you rent the condo out to non-related persons, you’re in good shape.  But if you try to play it cute and rent the condo out to your boyfriend, and you send your children to vacation with him for three weeks in the summer, the rental transaction is prohibited since disqualified persons have benefited from it.

In this case, it’s possible that the transaction could result in a penalty, or possibly invalidating your IRA, prompting an immediate disqualification and distribution including taxes and penalties, which could be a very bad thing.

Photo by Phillip Mc

Organization, Efficiency & Discipline

Nov 29th, 2010
by jblankenship.
2 comments

organization by BLW PhotographySimplification is usually beneficial to any pursuit.  If you can break down the basic principles of whatever “big thing” it is that you’re hoping to accomplish into simple concepts, you’ll do well in your pursuit.

This is true for whatever you’re hoping to accomplish – climbing Mount Everest (train, prepare, keep going up); write a book (gather information, organize, keep writing); or get a college degree (show up, pay attention, study).  In preparing for retirement, I’ve always broken the concepts down to organization, efficiency, and discipline.

Organization

In order to get things started, it’s important to know where you are in your financial life.  When you’re getting driving directions from Google Maps, the first thing they ask you is where you’re starting from.  The same goes for “mapping” your financial path.  Gather together your information and organize it so that you know what assets and what liabilities you have.  This can be as simple as listing everything out on a piece of paper, or a computer spreadsheet, or using some of the tools available on the internet, such as Mint.com.

Also gather your information about your monthly and annual expense requirements – preferably with an eye toward understanding what is a “must” expense and what is a “nice” expense.  If you’re having trouble balancing your budget (your income is less than your expenses) you’ll need to look at the “nice” expenses and determine what you can do without.

The last piece of Organizing is to set forth a goal – or several goals, depending on your situation.  Maybe it’s a goal to retire in five years… or to send your kids to college in 8 years.  Whatever is the goal, you need to quantify it (put it in terms of dollars and time), and so that you can map out the way to get there from where you are now.

Having everything organized will tell where you are financially, and knowing what your expenses are, compared to your income, will help you to understand what you can do to make changes in your financial life in order to reach those goals.

Efficiency

Now that you know where you are and where you’re going, it’s time to figure out how to get there.  As you know, there are many types of investment accounts, investment products, and the like, that you could use to increase your bottom line.  My preference is to use the most Efficient methods, in terms of placement of funds, taxes, expenses, and risks, in order to take you toward those goals.

We discussed the most Efficient placement of funds in an article some time back, entitled Retirement Savings – Where to Start.  This article will help you to understand which types of accounts are the best for saving your money.  The article also helps you with maintaining efficiency in terms of the tax treatment of your various savings vehicles as well.

Efficiency in expenses can be addressed by utilizing no-load index mutual funds and/or Exchange-Traded Fund (ETF) indexes.  These two types of investment products generally provide the most cost-efficient methods of investing.  In addition to the cost-efficiency, ETFs are also very tax-efficient, due to the structure of the funds.

Not only are indexes very cost-efficient and tax-efficient, but indexes are also risk-efficient as well.  If you invest in indexes you are getting (generally) the market’s movement in returns – something that less than 40% of managed funds can do regularly.

Discipline

Now that you’ve figured out the methods to use in getting to your goals, you have generated a plan to accomplish those goals.  This is where discipline comes into the picture.  In order to achieve these goals, you have to create your plan and stick to it, through thick and thin.

When the market is having difficulties and your accounts are experiencing a downturn, you need to maintain the intestinal fortitude to continue with your investing activities.  This is where a good financial advisor or just an accountability partner can help you out a great deal.

It’s maintaining the long-term view in the face of short-term “noise” like a market downturn that helps you to meet those goals.  Chickening out and selling at the wrong time can derail things.

Discipline also extends to creating your budget and sticking to it as well.  By reviewing your expenses and determining where you can reduce, you’ll be able to free up more money each month to eliminated debt and increase your savings balances.

Bottom line

By putting these basic tenets of Organization, Efficiency & Discipline to work for you, you will soon begin to see progress toward your goals.  Keeping things as simple as possible helps to ensure that you’ll stay with your plan.  As with everything else, let me know if you have questions!

Photo by BLW Photography

Update on Time Out of the Market

Nov 19th, 2010
by jblankenship.
No comments yet

paintbox by ZixiiAs an update to the article I wrote last month about the Cost or Benefit of Time Out of the Market, as promised I went back and ran the numbers for all the S&P 500 data that I could locate, starting in January, 1871.  This information is taken from an ongoing study by Robert Schiller for his book “Irrational Exuberance”, and since the S&P 500 index hasn’t actually been around for that whole time, the earlier numbers are an approximation of the index.

So anyhow, I looked at both five-year and ten-year data for a buy-and-hold strategy and the same periods for our momentum strategy (discussed in the earlier article).

In the buy-and-hold strategy, in the average five year period the return averaged approximately 6% per year, an aggregate of 31.49%, and for the ten-year periods, the average was a little higher, at just over 7¼%, for a total return of 72.60%.  Using the momentum strategy, these numbers increased for each period on average, to over 8% (42.49% total) and more than 10½% (105.38% total).

In the buy-and-hold tests, this strategy resulted in a positive (greater than zero) return in 68.34% of the five-year periods, and 75.76% of the ten-year periods.  By comparison, in the momentum tests, the results were even better:  94% positive returns in the five-year periods, 99.61% in the ten-year periods.

This is good information, but what about comparing the two strategies in terms of how often one is better than the other?  Not as often as you might think, given the results we see in the other categories:  67.90% of the time in the five-year tests the momentum strategy came up with a better result, and 69.62% of the time in the ten-year tests.

So, in roughly 7 out of 10 circumstances, you could be better off with the momentum strategy… when does the momentum strategy not work?  That is, when does a buy-and-hold strategy pay off better than the momentum strategy?

There are a few sustained examples (just using the 10-year periods, for brevity) where a buy-and-hold strategy gives a better result than the momentum strategy.  Those are the ten-year periods ending during these dates:

  • March, 1952 to May, 1966
  • August, 1967 to April, 1970
  • April, 1980 to May, 2002

If you don’t recognize these periods, these were the most rampant economic expansion timeframes that our market experienced over the past 140 years.  During these periods, the average monthly return on the S&P 500 was 0.66%, while the 140 year average was only 0.42%.  The aggregate return of the buy-and-hold strategy during these periods averaged 129.54% for each 10-year period, while the momentum strategy only returned an average of 109.54%, losing 2% for each year in the ten-year period.

So, the conclusion is that, while this is an interesting strategy, it’s not fool-proof.  If you’re looking only to have a positive return on your 10-year investing horizon, the momentum strategy seems to be almost waterproof on that score.  Just keep in mind that, as I mentioned previously, this strategy requires the utmost of discipline to the task – missing a few days here and there can derail the strategy altogether.  It might be interesting (if you’re so inclined) to use this momentum strategy on a small portion of your portfolio – but as I’ve mentioned before, you can certainly do much worse than following the buy-and-hold strategy.

I’ll keep doing the research on this (since I never met a spreadsheet I didn’t love!), most likely adding in analysis of the P/E ratios and any other pertinent information that I can track.  I’ll keep you posted!

Photo by Zixii

Social Security vs. Saving

Nov 12th, 2010
by jblankenship.
3 comments

bank safe combination by Todd Ehlers I received a question from a reader that sort of dovetails with the post from last week about payback from Social Security, so I thought I’d run through the numbers on his question here.  As you may have noticed, I never met a spreadsheet I didn’t like!

Here’s the question from the reader, verbatim:

started work at age 20 retire at age 70.

Over 50 years of work I average $50,000 a year.

If I put 10% of my income away every month from age 20 to age 70 how would I come out versus depending on the government social security checks I would receive after retirement.

Initial Reaction

My initial reaction to this question was that you’d be much better off with the savings option, since you’re saving at a much greater rate (10%) than the withholding, and for fifteen more years than the Social Security system takes into account.  However, that’s not altogether correct, since the Social Security system includes both your withholding and your employer’s withholding, for a rate in 2010 of 12.4%.  But this rate is much lower in the earlier years of the calculations. So let’s go ahead and run the numbers.

Assumptions

There are a few assumptions that we have to make in order to complete this problem:

  • In order to come up with an average of $50,000 per year, I first looked at the maximum Social Security withholding.  By calculating the average from 1961 to 2010, we come up with an average of $43,804.  This is a little less than the average that the reader suggested, but it will work for our purposes and keep the calculations a bit simpler.
  • Putting aside 10% each year requires that we come up with a rate of return for this investment account.  I used a simple 5% return, which is reasonable over that period of time.
  • I assumed that the side account is an IRA or a 401(k), so taxes have not been factored into the equations.

Calculations

As we saw in the previous post, earning the Social Security maximum over the final 35 years of your working career will give you a monthly benefit of $3,204 in 2011.

Saving 10% of your earnings (using the maximum Social Security wage base) over 50 years at 5% will bring you to a total in your IRA or 401(k) of $443,969.  Unfortunately, just running a few simple quotes from single premium annuity websites indicates that a joint and survivor annuity paying a $3,200 monthly payment will cost a total of $584,830 or $610,909 depending on the website you choose.  And that’s a fixed payment, not a COLA-adjusted payment like your Social Security benefit is.

However, upon the death of both you and your spouse, there is nothing left over – so the question becomes one of longevity.  If you both live long, full lives, the Social Security option works out much better.  If you and your spouse die earlier, any time before about age 85, there will be something left over for your heirs in the savings option.

Of course, the Social Security benefit could be taxed, up to 85% depending upon your other income.  Since the savings option is in a qualified account or an IRA, 100% of the disbursements will be taxed.  If it was a non-qualified account, just a regular savings or investment account, the taxation would be considerably less.

Conclusion

In the end result, it seems that the Social Security benefit option is a pretty good deal, especially since we all hope to live a long, full life.  The savings option works better if you die earlier than (roughly) age 85, providing a residual amount to your heirs.  This is a little different from what I’d originally thought, but when you consider that the average life expectancy of a male age 70 is roughly 84 (86 for females), there’s a high probability that you won’t outlive your savings, although there’s a similarly high probability that you will outlive your savings.

And finally, since you don’t really have a choice in the matter, the entire question is really moot – but an interesting exercise, nonetheless.

Photo by Todd Ehlers

Are You Really Diversified?

Oct 25th, 2010
by jblankenship.
1 comment

alter eggo by turtlemom4baconSometimes we fool ourselves.  Sometimes we think we’re doing the right thing, when in fact the result is that we’re not doing what we think we are.

I’m talking about your investment diversification.  Within your 401(k) you have certain options available for you to choose from:  a large cap stock fund, a mid cap stock fund, an international stock fund, and a bond fund.  Recalling an article you read somewhere… you know you need to split up your investments among many allocation options.  So, wanting to do this diversification thing right, you split up your 401(k) contributions with 25% in each of the funds available.  You’re well-diversified, right?

Wrong city, bucko.

Correlation

Welcome to correlation.  Investopedia defines correlation as: a statistical measure of how two securities move in relation to each other.  It’s pretty complicated, but the gist is this – if two securities are perfectly correlated, when one moves up or down, the other moves up or down in perfect relation to the other.  Such securities are said to have a correlation coefficient of +1.

On the other hand, if one security moves up and the other moves down (and vice versa, by the same proportions), they are said to be negatively correlated, with a correlation coefficient of -1.

Lastly, if one security’s movement has no relationship whatsoever to the other security – that is, any particular movement by one of the securities may or may not result in a movement in the same direction, the opposite direction or no movement at all.  These two securities have a correlation coefficient of 0 (zero).

Most pairs of common securities fit somewhere along the spectrum between +1 and 0, since very few are perfectly correlated.  Negative correlation is typically found in hedge funds – which are a costly, complex sort of asset to hold, being designed to work opposite of the general market movements.

With the above explanation, hopefully it becomes clearer to you why we want securities in our portfolio that are not correlated closely to one another… having such pairs of securities spreads out our risk of any single market event having adverse impact on everything in our portfolio.

Examples of Correlation

Back to our example portfolio, here are the correlation coefficients for your four choices, shown in a matrix:

1 2 3 4
1. Large-Cap Stock 1.00 0.96 0.93 0.28
2. Mid-Cap Stock 0.96 1.00 0.91 0.27
3. International Stock 0.93 0.91 1.00 0.44
4. Bond Fund 0.28 0.27 0.44 1.00

As you can see, the large cap, mid cap, and international stock choices are very closely related to one another.  That’s why, even though you thought you were well-diversified during the market slump a couple of years ago, everything you had took a dive.

This is why the first, most important allocation choice you can make is between stocks and bonds (we’ll get to some other allocation options later).  These two, of the choices you have, are the least correlated, so it’s very important to include these non-correlated assets together in your allocation scheme.  And then within your chosen split into stocks, you can choose some of the other asset options – large cap, mid cap, small cap, international – since those assets aren’t perfectly correlated, it can be beneficial to include diversification among these options as well.

The same goes for bonds – other types of bonds, such as Treasury Inflation-Protected bonds, are not perfectly correlated with the total bond market, so it might make sense to include some of these as allocation options as well.

What about other types of assets?

We’ve talked about some very basic allocations – but what about other types of assets?  There’s real estate (both domestic and international), emerging markets stocks, commodities, and others.  How does the correlation of these assets look?

The table below details the correlation matrix for these additional assets in relation to domestic stocks, international stocks, and bonds.

1 2 3 4 5 6 7
1. Domestic Stock 1.00 0.93 0.27 0.84 0.93 0.89 0.60
2. Int’l Stock 0.93 1.00 0.44 0.79 0.96 0.93 0.65
3. Domestic Bond 0.27 0.44 1.00 0.33 0.39 0.32 0.25
4. Domestic RE 0.84 0.79 0.33 1.00 0.83 0.68 0.44
5. Int’l RE 0.93 0.96 0.39 0.83 1.00 0.88 0.65
6. Emerging Stock 0.89 0.93 0.32 0.68 0.88 1.00 0.71
7. Commodities 0.60 0.65 0.25 0.44 0.65 0.71 1.00

As you can see in the matrix, adding these additional asset classes gives you even more diversification (per the correlation).  Commodities show up as the next most non-correlated, after bonds, which explains why this is an important asset class to include.  Not only are commodities not well correlated with stocks, they are even more non-correlated to bonds.

Real estate, both domestic and international, gives you some diversification, but not nearly as much as bonds and commodities – turns out that real estate, while not a perfect match for stocks, does follow the movement of stocks somewhat closely.

How?

You might be saying “but I don’t have those kinds of options available in my 401(k)” – what can you do?  This is part of why it can be useful to have other savings plans in your scheme, such as a Roth IRA or a taxable account.  With these other accounts, you can have the flexibility to invest in whatever asset classes you like.

Photo by turtlemom4bacon

3 Ways of Dealing Without Recharacterization

Oct 20th, 2010
by jblankenship.
1 comment

deal by D.C.AttyWith the new conversion opportunity made available by the passage of the Small Business Jobs Act of 2010 (see New Opportunities to Roth), there is one factor that is not available that you normally have when doing Roth conversions: recharacterization.

If you recall, the primary reason that you would want to recharacterize is if you converted funds and then, by the time you pay the tax, the holdings that you converted have dropped in value.  So, instead of paying tax on something that is much less in value than previously, for a Roth IRA conversion you can recharacterize the conversion up to October 15 of the following year (see Help Mr. Wizard – I didn’t wanna do a Roth Conversion for more details on recharacterization)

But there are ways to reduce the risk associated with your Deemed Roth Account Conversion (since you are not eligible to recharacterize the conversion).

For one thing, you could use dollar-cost averaging to spread the risk of market fluctuations over several points in time through the year.  Simply split your intended conversion amount into four amounts, and convert one of those amounts each quarter, for example.  This way if the market drops through the year, you’re converting funds at the lower values.

Another option would be to spread the date-specific risk over several years, by converting smaller amounts each year.  This would also reduce the risk of adverse market results, and spread out the tax over several years (if possible).

Yet another choice could be to convert only those assets that have very low volatility, such as bonds.  The probability of a major drop in value is much lower for these assets, so your need for a recharacterization would be far less likely.

There are many other, more complicated ways to reduce your risk against such a situation, but these are a few that are easily implemented.  Hopefully this will help you in your process of converting retirement plan assets to Roth.

Photo by D.C.Atty
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