One of the best Roth conversion strategies I've come across requires making many smaller "Roth conversion sub accounts' in January and then selecting the best performing (between January - April of the following year) "sub-account" to convert. "Sub-accounts" not converted are then re-characterized and returned to deferred IRA status.
Here we are in October, when, historically speaking, the market performs its best over the next six months (Oct-Apr). Might this not be a good time to consider this same strategy?
Here's one scenario. Lets say back in January I divided my IRA ($50,000 account) into (5) $10,0000 sub-accounts (that were designated for Roth conversion). Each invested differently. I will use T. Rowe Price funds for this example since I am familiar with their performance. Each sub-account holds just one fund, so (5) funds each valued at $10,000 as of January 2017.
January 2017 - September 2017 has been very good YTD for these funds. So much so that a these $10,000 conversion would be valued at the following for a few funds I track ( I own each as well):
PRWCX = $11,206, PRHSX = $12,286, PRIDX = $13,106, PRMTX = $12,666, and PRNHX = $12,566
On a $10,000 conversion, at a 15% tax, $1500 would be due in April 2018. As you can see, 4 out of the 5 funds could fully fund that tax bill with the tax free growth since January 2017 when each conversion was set up.
In fact, had you not set up these conversion accounts in January you could do it now and pay the additional taxes on the October 2017 value.
The 15% taxes for the 4 funds that made the cut (PRWCX didn't since it has grown less than the tax liability) would be $1500 on the original $10,000 plus the taxes on the gains since January.
So if you converted in October you would owe (taxes in parenthesis) for each of these funds:
PRHSX = $12,286 ($1843)
PRIDX = $13,106 ($1966)
PRMTX = $12,666 ($1900)
PRNHX = $12,566 ($1885)
The gains so far this year (January - October 2017) would cover the tax liability which...
is a very good thing. One could merely go to cash or if history is in you favor continue to stay invested until April 2018 (tax filing for the conversion).
As important as having a Roth conversion strategy one should also have a good sense as to the tax liability on these conversions as well as how to pay for these conversions (taxes).
Comments
If you want to convert $10K, then you just pick the fund that did the best. (Technically you have until October 15, 2018 to do the recharacterizations, so you could watch and wait a long time to see which one does the best.)
You'll owe $1500 in taxes. As you said, you should have a good sense of how to pay for this. You may be suggesting that this come out of a Roth. Generally (unless one is trying to keep one's income down), that's not a good idea. Once money is in a Roth all growth is tax-free. It doesn't get any better than that. Money from anywhere else is less valuable.
Even if you are going to pull the tax money from a Roth, you likely want to pull it from the fund(s) that you expect to do worse going forward. Those may not be the same funds as just did well this year. We all know that "past performance does not guarantee future results", YMMV, etc.
Thanks for your comments. I see your point.
I have also read that the best time to convert to a Roth would have been at a market low. "Convert to Roth low when potentially more under priced shares can be sold "cheaply". Ultimately it is the after tax return investors should be striving for. Since all Roth returns after inherently "after tax" returns, I strive to maximizing as much of the 15% tax bracket by considering adding to my taxable income up to the 15% tax bracket maximum.
I should also say that I am trying to stay eligible for ACA Insurance subsidies which can be at odds with Roth conversions and maximizing tax brackets.
Much like "after tax returns on investment", I believe even income (whether earned or unearned) can be looked at through the lense of "after tax income".
msf,
Three questions:
1. Why pick the fund that did the best to convert the $10K?
2. I understand why it is generally not a good idea to pay the tax from the Roth. But what do you mean by "unless one is trying to keep one's income down"?
3. Why pull the tax from the fund(s) that you expect to do worse going forward?
Mona
Using Bee's example, the current combined value of all five accounts is $61,830. If you recharacterize all but the one that did best (PRIDX), you wind up with $13,106 in the Roth and $48.724 recharacterized back to the traditional IRA. If you recharacterize all but, say, PRWCX, you wind up with "just" $11,206 in the Roth and $50,624 recharacterized back to the trad IRA.
Either way you pay taxes on $10K, but leaving PRIDX as the converted fund results in the largest percentage of your portfolio converted into the Roth for the same amount of tax.
That's not to say that you're stuck with these investments. You could choose to exchange PRIDX inside the Roth for PRWCX and/or exchange PRWCX inside the traditional to PRIDX, or anything else. Perhaps I should have said you pick the "subaccount" with the highest value to keep as a Roth, and recharacterize the others.
2. Bee mentioned that an objective is to keep income low enough to qualify for ACA subsidies. Getting $1500 out of a taxable account to pay for the Roth conversion could result in recognizing capital gains, and thus increase income. That extra income might disqualify Bee from any ACA subsidy. On the other hand, getting the $1500 out of a Roth account would not increase income, so the ACA subsidy would remain safe.
3. Say you have two funds each worth $1500, the amount of the tax. You expect the first to double in the next four years, the other one to grow by 50%. All else being equal, you'd rather keep the first investment and sell off the second, since you'd have more money ($3000 vs. $2250) at the end of four years. Of course there are other considerations, notably asset allocation and risk. In glossing over those considerations, I may have underestimated their importance.
Once you do a conversion, it is irrevocable.
Plan accordingly. Don't get trapped pushing yourself into a higher bracket or Medicare Surcharge area.
Per Vanguard:
" IRA recharacterizations of conversions are going away.
Chief among the bill's features affecting retirement savers is the elimination of an investor's ability to recharacterize a conversion to a Roth individual retirement account (IRA) after the 2017 tax year."
[ https://advisors.vanguard.com/VGApp/iip/site/advisor/researchcommentary/article/IWE_InvComVanguardOnTaxBill ]