The Roth Conversion Time Machine
What if you knew in advance that ABC was going to gain 20% and XYZ was going to drop
10%. That could be considered insider trading which is illegal. Looking back in time
to see how much a symbol gained or dropped is legal.
Do you remember Laugh In when Emily Litella (Gilda Radner) would say something, was
told she was wrong, and then say “Never Mind”? Well, that functionality is actually
built into the Roth Conversion process. It is called recharacterization, but
you can think of it as “never mind” or the ability to undo a conversion if it
was a mistake.
Basically speaking it is better to lose money in the taxable IRA rather than in the
tax free Roth. If you are limited on the size of the conversion that you can afford,
you want to convert the symbols that will have the highest gains. Recharacterization
allows you to do this if it is done the proper way.
Let’s start by creating a single Roth account at your broker and converting, transferring,
$10,000 of ABC and $10,000 of XYZ into the new account. On day 1 your Roth has a
value of $20,000. Over time, before April 15 when the taxes are due (later with
extensions), ABC gains 20% to $12,000 and XYZ drops 10% to $9,000.
The current value
of your Roth is now $21,000, a 5% overall gain for the account. You tell your broker
to recharacterize the XYZ conversion “in kind”, moving the transferred shares back to
your traditional IRA. The broker will have to debit your Roth account the original
$10,000 plus or minus any gains or losses on “the account”, so it will cost your
$10,500 to say “never mind”.
If the conversions are done into an existing Roth account, the ROR is calculated on
the total value of the account on the day of the conversion and on the day of the
Now let’s do it again, the right way this time. You start by creating two new Roth
accounts at your broker. You can then rename them as Roth ABC and Roth XYZ. Do both
conversions as in the first example but this time each symbol goes into its own
separate Roth account. On day 1 each Roth account has a value of $10,000. On April 15
Roth ABC is worth $12,000 a 20% gain and Roth XYZ is worth $9,000 a 10% loss. As in
the first example you tell your broker to recharacterize the XYZ conversion
“in kind”. The big difference in doing it the right way is your cost. The broker will
debit your “Roth XYZ” account the original $10,000 minus the 10% losses on
“the account”, so it will only cost your $9,000 to say “never mind”.
The final result for tax purposes is the same which ever way you did it, you only converted
$10,000 of ABC, XYZ never happened, so you only owe the taxes on $10,000.