This article originally appeared on Morningstar.com in 2010. In case you missed it, we're running it again as part of our IRA Improvement Week.
In investing, as in the rest of life, a great starting point is to admit that there's an awful lot you don't know for sure. Stocks may have outperformed bonds over long periods of time, but there's no guarantee that'll be the case in the future. Your fund manager may have walloped the market over the past decade, but he could lose his touch. Tax rates sure look like they'll go up in the future, but there's no certainty that your personal tax rate will be higher or lower by the time you get around to retiring.
In all such situations, there's invariably a good way to hedge your bets so you're not casting your lot with a single outcome or another. (Splitting the difference can be a great strategy, as I discussed in this article.)
Diversifying among stocks and bonds and using dollar-cost averaging are two ways to say that you don't know what various assets will return in the future. Those who own mutual funds would do well to mix active funds with at least a little bit of passively managed offerings. And putting some of your retirement assets in tax-deferred vehicles while stashing others in investments that offer tax-free withdrawals is a way to say "I don't know" about the future direction of tax rates.
Based on a past Morningstar.com Discuss thread, some of you have also said "I don't know" about IRA conversions--and your financial and tax advisors may be feeling similarly bewildered.
The confusion is understandable, because deciding whether to convert involves getting your arms around myriad factors. The key one, of course, is your tax rate when you make the conversion versus where it will be when you're retired and taking distributions. To correctly forecast that, you'd need to have some insight into not just your own income situation, but also how the government is apt to tax everyone's earnings in the future--obviously a tall order.
And if you decide to move ahead with a conversion to a Roth, you're betting that you'll live long enough to recoup the tax hit over the life of your investment. Fluctuating investment values inject another element of uncertainty into the "to convert or not" debate, because you'll owe less in taxes if you make a conversion when your account is at a low ebb than if you converted after your investments have done well. (Taxes due upon conversions are based on nondeductible contributions and investment earnings.)
Fortunately, investors who are feeling paralyzed about the conversion decision have more than one escape hatch.
If it turns out your conversion was ill-advised for whatever reason--maybe you don't have the money to pay the taxes or your account has dropped a lot since you converted--you can undo your conversion via a recharacterization. I discussed the nitty-gritty of recharacterizations in a previous column, but the bottom line is that this amazingly generous provision in the tax code can be a godsend to those who convert, then later realize they shouldn't have.
Perhaps an even better way to safeguard against a bad decision, however, is to admit all that you don't know at the outset of the conversion process. If that's the case, the best way to hedge your bets will be to do several partial conversions rather than converting your assets from traditional to Roth all in one go.
To date, most of the discussion around partial conversions has centered around converting IRA assets over multiple years. Doing so can help you ensure that the conversion doesn't push you into a higher tax bracket when you convert, and it also helps hedge against the fact that we don't know the direction of future tax rates across the board.
One unheralded partial-conversion strategy, however, is to convert smaller sums throughout a single calendar year. That won't help on the tax-diversification front, but it will help ensure that you don't convert (and owe taxes on) a big pile of assets that later drops substantially in value. If you do partial conversions over a period of several months and the market drifts down during that time, the taxes you'll owe on the investment-earnings component of your IRA assets will also go lower.
Of course, the opposite could also happen--you could do a partial conversion of your IRA assets one month only to see your remaining traditional IRA assets shoot up in value the next. In such an instance, you would've been better off doing a full conversion all at once, when your account value was at a lower ebb.
A devil's advocate might say that rather than monkey with partial conversions, you're better off recharacterizing from a Roth back to a traditional IRA after the market has dropped sharply. You then convert again at lower prices, thereby reducing your tax hit. There are a couple of drawbacks to this approach, however. First, there are time restrictions on converting after a recharacterization, as detailed in this article. Perhaps more importantly, successfully pulling off such a strategy would require that you have confidence in your ability to call the market's bottom, something with which most investors haven't had much success.
No Picking and Choosing
While partial conversions are an advisable strategy for many investors, bear in mind that you can't pick and choose which IRA assets to convert--for example, you can't convert all of your nondeductible IRAs and leave your deductible IRAs intact, though that would result in a lower tax hit because you've already paid taxes on those nondeductible contributions. Instead, the IRS considers all of your IRAs as one big pool when calculating your tax burden.
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