The importance of timing a Roth conversion

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Conventional wisdom holds if you convert a traditional IRA to a Roth, you should never pay the conversion taxes from IRA assets, because you’ll deplete IRA assets that might otherwise be available to grow on a tax-deferred basis.

The withdrawal from a traditional IRA to pay the conversion taxes is also a taxable distribution and you’ll generally pay a 10% penalty if you’re under age 591/2. It’s also conventional wisdom that converting a traditional IRA to a Roth IRA is tax neutral so long as income tax rates remain the same at the time of conversion and after retirement.

Conventional wisdom isn’t always right

Let’s assume the following:

  1. You’ll be 591/2 or older as of January 1, 2015, and you’ve had a Roth IRA for at least five years.
  2. You own a stock in your traditional IRA that could be a candidate for higher-than-average gains. For example, let’s assume you own 10,000 shares of Acme Pharmaceuticals, a biotech that has a drug pending before the FDA. The shares are currently trading at $10. After diligent research, you’ve determined the Acme stock could climb to as much as $50 if the drug is approved but could drop to $1 if not approved. The FDA deadline for approval is October 1, 2015.
  3. You want to convert your traditional IRA to a Roth in 2015, before the potential appreciation in Acme stock, but don’t have any cash available to pay the conversion tax, or don’t want to pay the tax from other (non-IRA) assets.

Now let’s assume Acme’s drug receives FDA approval and the stock jumps from $10 to $50.

Result if you don’t convert
Your traditional IRA would now hold 10,000 shares of Acme stock worth $500,000. Assuming you earn 6% until your retirement in 10 years, your account would grow to approximately $895,000. Assuming a 28% federal income tax rate, the after-tax value of your account would be $644,705 at retirement.

Result if you do convert
The stock was worth $100,000 at the time of conversion, and assuming a 28% tax rate, the federal income tax is $28,000, due when you file your 2015 tax return. When the drug is approved, the value increases to $500,000.

On October 1 you also receive a tax-free $28,000 qualified distribution from the Roth IRA to pay the conversion tax. Now your Roth IRA balance is $472,000. Assuming a 6% earnings rate, after 10 years your IRA would have grown to approximately $845,000 — about $200,000 more than if you had not converted — even though tax rates have remained constant and you’ve paid the conversion tax from IRA assets.

This isn’t magic. You’re simply paying conversion taxes on the stock before appreciation, instead of paying on the fully appreciated value at retirement. By paying the conversion tax from the Roth — you’re able to convert your entire traditional IRA, keeping the funds in the Roth until you actually make a withdrawal to pay the tax.

Recharacterize if things go wrong
But what happens if you turn out to be wrong, the FDA does not approve Acme’s drug, and the stock drops to $1? In that case, you can simply undo the conversion. You have until October 15, 2016 to recharacterize the Roth IRA back to a traditional IRA. For tax purposes you’ll be treated as though the conversion never happened.  

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2016.

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