Roth Conversion – What Could Possibly Go Wrong?

warning by jurvetsonIt is expected that in 2010 there will be more Roth IRA conversions than in any year in the past – maybe all years added together.  With all this converting and cavorting going on around IRAs and Roth IRAs, there are bound to be some problems arise. One particular type of problem that could arise would specifically impact 2010 conversions – those conversions that qualify to be eligible for the special tax spreadout over the following two years.  That problem is the impact you’ll have when a significant sum is converted in 2010, the option for tax payment over 2011 and 2012 is chosen, but alas, the investments chosen go awry, terribly so, eroding your ability to pay the tax. Specifically, this situation can cause a huge problem if the downturn on the investments occurs long after the conversion – long enough to be beyond the scope of the recharacterization possibility.  Below is an illustration of the situation I’m talking about.


Here’s an example of the problem:  You have a significant sum in your IRA – let’s say $500,000, just for grins.  You have run the numbers and determined that it makes sense for you to convert this entire IRA to a Roth IRA in 2010, electing to spread the tax over 2011 and 2012, as you’re eligible to do.  You’ve chosen to do this because you expect that by retiring in late 2010, you will have a much lower taxable income in 2011 and 2012, thereby reducing the tax bite. You estimate that your taxes will be $200,000 on the conversion, and since you don’t have that kind of scratch just sitting around in a savings account, you expect to pay that tax from the proceeds in your Roth account, $100,000 in 2011 and $100,000 in 2012.  Furthermore, you consider yourself a sharp cookie – you’ve decided to invest the entire amount of your Roth IRA in the hottest new mineral exploration company; you heard about it from a buddy at the club, and he’s always making money, or so he says. By the October 15, 2011 (the last day that you could choose to recharactrize the conversion), your mineral exploration stock investment has grown 50% – now your Roth IRA is worth $750,000.  Things are going great!  Since the account has grown, you decide not to recharacterize the conversion, and you’ll just sit back and watch your stock grow. Problems on the Horizon Until… along about mid-March in 2012, the company you’ve bought into becomes a party of an environmental lawsuit, placing a restraining order against further exploration activities.  The lawsuit is not expected to have merit, it will just be a bump in the road – but the stock falls out of favor, dropping in value by 50%.  Your Roth IRA is now worth $375,000… and you have to pull out $100,000 to pay taxes in 30 days.  After doing so, the account is now worth $275,000. Now you’ve decided that your hot tip wasn’t such a hot tip, but since you have faith in the company and truly believe that the lawsuit is just a bump in the road, you hang on.  And, in fact, in mid-June, the stock does come back, but nowhere near the 172% you’d have to gain to get back to the all-time high, and not even the 45% that you’d have to gain just to get back to your original $500,000.  More like about 20%, which brings your account balance up to $330,000. these boots were made for throwing by Coyote2024More Footwear Decends Just in time for the other shoe to drop:  in late October of 2012, the CEO of your mineral company is arrested for insider trading – and the stock takes another dive, losing 30%.  Your Roth IRA account is reduced to $231,000 – you decide the rollercoaster ride is over for you and you sell out, putting all your money in the money market at a 1.5% return.  When it comes time to pay the other half of the tax in April of 2013, you’ve achieved a bit of a return on the money market holdings, so that your account is now worth approximately $233,000 – but you’ve got to pull out the tax payment.  After you pay your taxes, your nest egg is now worth $133,000.  You’d planned on having at least $300,000 at this point. and now what you have left will be tough to get by on.

What Can We Learn?

What could have been done to avoid this?  Presumably you had weighed the risks and the plan met your needs, as long as the aforementioned problems hadn’t occurred.  This comes down to the long-time planning adage of not putting all your eggs in one basket… you should never try for the “home run” sorts of returns with your entire nest egg.  I’d say you should give up on taking your buddy’s stock tips as well – especially with regard to investing more than you can afford to lose in any one issue as was illustrated. Of course, something similar could have happened in a diversified account; we have only to look at late 2008 and early 2009 for an example of an across-the-board downturn.  But the likelihood of a repeat of such a downturn is very low, and diversification across many asset classes can provide a buffer against that possibility. In addition to diversification across asset classes, it makes great sense to diversify across tax treatment as well.  In your savings plan you should have some money invested in all three types of tax treatment: capital gains taxable, tax-deferred (as in an IRA), and tax-free (as in a Roth IRA).  Of course if you have the ability to have all of your money in a tax-free account (as the example did) that would be great, but as you can see, getting the money to the account could be problematic.
Photo #1 by jurvetson
Photo #2 by Coyote2024

About the author

Jim Blankenship, CFP®, EA

Jim Blankenship is the founder and principal of Blankenship Financial Planning, Ltd., a financial planning firm providing hourly, as-needed financial planning and advice. A financial services professional for over 25 years, Jim is a CFP professional and has earned the Enrolled Agent designation, a designation that qualifies him as enrolled to practice before the IRS. Jim is also a NAPFA-registered financial advisor, which designates him as a Fee-Only Financial Advisor.

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