Roth Change Strategy Can Lower Your Tax Bill

NEW BERLIN, Ill. (MainStreet) -- If you have an IRA you probably know about the concept of a Roth IRA conversion -- in which you take distribution of a portion of your IRA and transfer that money directly into your a Roth IRA, paying tax as you go. Then the Roth IRA can continue to grow tax free (as Roth IRAs do) and you'll never owe tax on your qualified distributions.

In addition, if the investments you've made in the Roth IRA have lost money, before Oct. 15 of the following year you have the opportunity to recharacterize your Roth conversion. If you didn't recharacterize, you'd be paying tax on a conversion amount much lower now if there was a downturn in the investments, so your average tax rate is much higher than you'd hoped. By recharacterizing, you can undo the conversion or a part of it.

You can use the Roth IRA recharacterization option to your advantage.

I had a question raised to me recently about using the recharacterization option to your advantage. Here's the gist of the strategy: If you have an IRA worth, say, $100,000, you could convert it into two Roth IRAs, one half invested in a 2x leveraged bull-oriented investment and the other in a 2x leveraged bear-oriented investment.

If the two investments go flat for the year, your conversion could be recharacterized with no tax consequence. If the market went up by 10%, though, your bear holding would be down 20% (being leveraged 2x) and the bull holding would be up 20% (vice versa had the market dropped). This would give you the opportunity to recharacterize only the bear holding, leaving you with a traditional IRA worth $40,000. Your Roth IRA would be worth $60,000, although you would have to pay tax only on the original $50,000 converted at a 25% tax rate that works out to $12,500 in tax, which would only be 20.83% on the Roth IRA.

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