Thoughts, ideas, suggestions and education from financial adviser Jim Ludwick, Founder of MainStreet Financial Planning, Inc. of Odenton, MD; Washington, DC; New York City, and Santa Barbara, CA

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Saturday, August 22, 2009

Roth Segregation Strategy

A recent article on Roth IRA strategies in a financial industry publication authored by David Marotta reminded me of how many opportunities are available to save or pay income taxes now since rates are expected to rise in the future.

The most intriguing idea in Marotta’s article is labeled “Roth Segregation Strategy”. That caught my attention. Basically, Marotta suggests converting traditional IRA money into multiple Roth IRAs, each in a different asset class, (one class might be large cap growth) to capture a dramatic increase in a particular asset class resulting in a cash flow advantage over the tax cost of conversion.

Marotta suggests that the owner see how each Roth IRA performs over the time period allowed to “recharacterize” or return them to a traditional IRA where they originated and not pay the tax that would have been incurred. This technique is available to all taxpayers in 2010 and 2011 when income limits are eliminated for traditional IRA conversions to Roth IRA.

Can you have your cake and eat it too? Marotta reminds us that you only have to pay taxes on the conversions not “recharacterized” at the end of the allowable time period which can be lengthened by tax deadline extensions. That could be 21 months if you converted in January and made the “recharacterization” decision by mid-October of the next year which is the ultimate filing deadline. He suggests only paying taxes (on the original conversion value) on those that have had significant gains. Otherwise return those with less than stellar increases to the traditional IRA with no tax due.

How does that work? Here’s my simple calculation (this is not tax advice, only education): You create five different Roth IRAs funding each with $10,000 in January of 2010. During the next 21 months (you may make a decision sooner) you end up with a 10% gain in one, minus 5%, in the second one; 10% gain in the third one; 15% gain in the fourth Roth IRA and a 25% gain in the fifth Roth IRA.

Now if your effective tax rate (combined state and federal) is 25% , then you could hold onto Roth IRA number five paying $2,500 tax for conversion and end up with $12,500 in your Roth IRA experiencing a net zero cash flow and no future income taxes on that Roth IRA. All other converted Roth IRAs could be returned to the traditional IRA if you only wanted to have a zero or less than zero tax consequence. That less than zero tax consequence would happen if Roth IRA number five gained more than 25%, a happy prospect.

I can imagine lots of folks keeping conversions that saw reduced tax consequences rather than just none or less than zero as I explained in the last paragraph. For example I could pay $2,500 tax on Roth IRA number four, and end up with a $11,500 Roth IRA at a net cash flow cost of only $1,000. Not a bad price to pay for no further taxes.

Warning: In practice, custodians usually withhold 20% of the converted amount and you have to gain it back (or balance things out) upon filing of your tax return. So beware of the cash flow consequences of conversion and recharacterization. This is not a simple exercise and does take planning. However, it provides our firm and our colleagues’ firms with another opportunity to benefit our clients.

(David John Marotta is president of Marotta Wealth Management, Inc. of Charlottesville, VA)

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