Risk-Sharing Implications for Roth IRA Conversions: Fact and Fiction

Abstract

We investigate the risk-sharing implications of taxation associated with the option to convert a traditional IRA to Roth IRA. Although the conversion option may create value for savers by potentially reducing their tax burdens, the risk profile of their holdings may change. Delaying payment of the conversion tax creates a leveraged equity position for the taxpayer. We show that the conversion decision depends on the dynamics of the underlying asset, including volatility and its path through time. Moreover, how asset dynamics affect the ultimate payoff depends on the financing source for the conversion tax payment. These factors render some conventional wisdom around conversion unreliable.