Ahh the mulligan, the casual golfer's one true friend on that 18-hole, USGA top-rated course that challenges our patience and makes us wonder why we started playing this fudgin' game in the first place. The mulligan is our safety net, our excuse-me check-swing, our one true do-over.
Why should it only apply to golf? What if you could use it to save money? Well, you can and, depending on the circumstances, it could be a lot of money. I'm referring to a Roth conversion recharacterization. Believe it or not, it can be a huge benefit to you in terms of getting the most out of what you're paying for in taxes.
The IRA Mulligan
When markets have been bad, this is exactly when investors could use a mulligan in one form or another. For example, if you converted any money from your Traditional IRA to a Roth IRA in December 2008, by March you would have watched the value of that Roth account drop like a rock. That would have been a perfect time to recharacterize your Roth account back to your Traditional IRA and start over again, this time for the 2009 tax year. This trick works for a Roth contribution as well. The only difference between the two is that you could recharacterize the contribution back to a taxable account.
What's the value of this move? Assume you made a $50,000 Roth conversion. That money comes out of a Traditional IRA and is considered a distribution. All distributions from a Traditional IRA are taxed at your ordinary income rate. If you are under 59.5 they are assessed an additional 10% penalty.
A Savings Hole-in-One
It's ideal to make Roth conversions when you believe your tax bracket is likely to increase in the future. We'll assume that you are in the 25% bracket and want to take full advantage. Upon making the distribution of $50,000, your tax incurred will be $12,500 ($50,000 x 0.25); $50,000 will now be sitting in your Roth account.
Let's say that over a period of time the market takes a 10% drop. This is a conservative notion considering what happened from 2008 through early March 2009. You have now paid the full amount of taxes on a $50,000 conversion that's only worth $45,000. In other words, you've paid $1,250 ($12,500 - ($45,000 x 0.25)) more in taxes on that $45,000. You would have been better off if you just waited to do the conversion in the first place.
This is where the Roth recharacterization ("mulligan") can be used to its full advantage. Using this tool, we can reverse the Roth conversion and move the cash or securities back into your Traditional IRA and undo the taxes paid (i.e. the $12,500). We can then reapply a conversion, taking advantage of the market while it's at a lower value. This will continue for the subsequent tax year as long as it still makes sense. The $50,000, at the lower market value, can then grow tax free in the Roth IRA and avoid required withdrawals. Of course, you can always just recharacterize the original Roth conversion and simply forgo the reconversion altogether.
We should note that there are restrictions on how often you can make a conversion after a recharacterization in the same year. The IRS has set rules in order to keep this kind of thing from being done constantly. You can't convert to a Roth, recharacterize and then reconvert all in the same tax year. You also can't reconvert back to a Roth IRA within 30 days of the recharacterization of the original conversion from the Roth back to the Traditional IRA. Roth conversions for a given tax year must be done by the December 31 deadline.
Another trick while making your Roth conversion is to open two Roth accounts and split the distribution evenly dollar-wise. Break the accounts up into assets classes that tend to be less correlated with each other. As the market fluctuates, low-correlated asset classes differentiate in returns. If one asset class posts a positive return and another posts a negative return, having them in separate accounts will allow you to recharacterize only a portion of the entire conversion. Making a conversion to a new Roth account will also allow you to avoid having to file an additional tax form (Form 8606) for partial recharacterizations, as well as having to calculate losses attributable to the conversion.
Unlike Form 8606, which isn't always necessary, you should expect to deal with IRS Form 5498 and Form 1099-R. Your IRA custodian will first report your initial conversion as an IRA contribution on IRS Form 5498 and then again as a contribution back to the initial IRA as you recharacterize. In this case, you will receive two copies of Form 5498. You will also receive one Form 1099-R for the IRA that first received the contribution. Form 1099-R is used to report distributions from retirement accounts. On Form 1099-R your custodian will use a special code in box seven to indicate that the transaction is a recharacterization and therefore not taxable. On form 1040 you will report a distribution from your Traditional IRA and a contribution to a non-Roth IRA, which in essence cancel each other out.
New Rules for 2010
In addition, new Roth conversion income rules take effect in 2010. Many people have written articles solely dedicated to this "chance of a lifetime." As income limits are eliminated and individuals gain the ability to spread the income generated from an IRA distribution out over 2010, 2011 and 2012 as they see fit, this recharacterization strategy will become that much more useful should there be a down market.
As for 2009, you will still need to abide by the income limit for a conversion, which is $100,000. Individuals filing under the joint or single status cannot make a conversion if their modified AGI is above $100,000; married individuals filing separately can't make a conversion at any time. Those who file separately and have not lived with their spouse at any time during the year are considered to be in the single filing status. Keep in mind that Roth conversions don't count toward your modified AGI when figuring conversion limits, so as long as you are under the income limit you can convert as much as you like and it won't push you over the $100,000 limit. You should bear in mind that it will still affect your taxable income and tax bracket. Don't convert so much that it pushes you into a higher income bracket.
The Bottom Line
Taxes are a certainty, but don't pay more per tax dollar than you have to. If you've made a conversion (or a contribution) prior to a down market, recharacterize your Roth back into your Traditional IRA (or taxable account) and save money on your tax bill. Go ahead and claim your investing mulligan. It's definitely a hole-in-one.