Retirement Investing: Analyzing the 'Roth' Conversion and Re-Characterization Options

Abstract

The paper explores a rich example of the importance of tax options for investment management. Starting in 2010, all individuals, regardless of income level, can convert their “traditional IRAs” into “Roth IRAs” by paying ordinary income tax on the market value (at the time of conversion) of the assets being converted. In particular, even individuals with the largest tax-deferred accounts can convert some or all of their tax-deferred holdings to Roth IRAs, prepaying the ordinary income tax. The U.S. tax law also permits investors to reverse or “re-characterize” these conversions at an individual account level until the final income tax filing deadline for that tax year (i.e., October 15th of the following year). The resulting opportunities are very different than for traditional tax-deferred investments. We examine the costs and benefits of converting to a Roth IRA from a traditional tax-deferred account and analyze the optimal conversion decisions by investors absent the re-characterization option. We then allow the investor to reverse (re-characterize) these conversions decisions and examine the implications for asset location. The insights that arise with respect to optimal conversion go beyond the conventional wisdom, such as converting if and only if the investor’s current tax rate is below his anticipated future tax rate. Volatility is very valuable for positions that are subject to potential re-characterization, which is in sharp contrast to the traditional asset location advice. Re-characterization leads to substantial optionality for investments in certain tax-deferred accounts. These perspectives raise interesting challenges for understanding the stochastic and dynamic structure of government revenue.