'Roth' and Traditional Tax-Deferred Investing: Asset Location, Conversion and Re-Characterization Options

Abstract

In this project the principal investigators plan to explore the impact of Roth IRA investing upon optimal asset location as well as the value of various types of tax-deferred wealth. The interest in Roth IRAs is likely to accelerate with the elimination next year of income caps that currently prevent high income investors (many of whom have substantial tax-deferred balances) from converting to the Roth form. A key feature associated with the conversion option to convert a traditional IRA to a Roth IRA is the “re-characterization” option that allows the investor to reverse his conversion until his tax filing deadline during the following year (which is as long as 21.5 months), creating strong incentives to hold very volatile investments in situations subject to the potential for re-characterization. This is in sharp contrast with the traditional advice associated with tax-deferred investing, i.e., to hold high-yields assets in tax-deferred account. Our work will link the exercise of the re-characterization option to past performance as the investor will optimally re-characterize all but the strongest performing accounts since conversion. Under some circumstances (for example, if the option is far out-of-the-money) it would be optimal to exercise the re-characterization option prior to its maturity in order to lengthen the subsequent conversion option. We plan to analyze this compound option and characterize the optimal exercise boundary as a function of time and the extent of appreciation or depreciation since conversion. The ability to re-characterize highlights the centrality of the conversion option by making it optimal for the investor to always convert, as the investor can re-characterize as needed. This work builds from and contrasts with earlier research that addressed issues involving taxable and tax-deferred investing simultaneously, but which did not distinguish between Roth and traditional tax-deferred investing.