The Value and Use of the IRA Recharacterization Option

Abstract

The recharacterization option allows IRA owners who convert a traditional IRA into a Roth IRA to choose the better of Roth or traditional treatment (for tax purposes) after returns are known. The authors used option-pricing models to estimate the value of this option and examined strategies to maximize its value. Using a simulation that applies a simple recharacterization strategy over a long time horizon, the authors show its potential value in private wealth management.

The recharacterization option is a right given to a U.S. IRA owner who converts a traditional IRA into a Roth IRA. The owner may choose to have the IRA treated as a Roth IRA (for tax purposes) if the portfolio increases sufficiently in value before taxes are paid in the next tax year or to have the IRA “recharacterized” back to a traditional IRA otherwise. This asymmetric tax treatment can create tax savings for the IRA owner. This article applies option-pricing models to establish the value of the recharacterization option and discusses strategies to maximize the value of this option. The multiple-year and multiple-portfolio approaches to using the recharacterization option can create considerable value for an IRA owner. We simulated the results for an IRA owner using a simple recharacterization strategy over a long time horizon. The recharacterization option promises to be an important tool in private wealth management.

The aggregate amount of traditional-to-Roth conversions should increase in future years, in part owing to the elimination of the income limit on potential converters. The recharacterization option provides substantial additional economic motivation for these conversions. A one-time use of the conversion/recharacterization option is worth the IRA owner’s tax rate times the value of the option. Pursuing the conversion/recharacterization process for multiple periods adds substantially to the expected gain. And using a multiportfolio approach, especially if the portfolios are shifted into riskier assets, would add even more value. Of course, the owner could do both. When using a multiperiod strategy, the IRA owner could divide a large IRA into several smaller IRAs and then pursue the conversion/recharacterization strategy for each IRA. The owner would recharacterize only those IRAs whose returns did not exceed their hurdle rates. Of course, valuation models express only the expected gain in wealth, not a particular outcome. For example, if the owner tries the conversion/recharacterization process three times and the market declines each time, the owner will have no gain. But if the owner converts a portfolio and asset values appreciate substantially, the owner’s gain is considerable.

This article provides simulation results for a multiperiod strategy that leads to enhancements of IRA terminal values averaging about 16% (with a 90% confidence interval from 9% to 26%). If the taxes on the Roth conversions are paid from taxable investments, the terminal value is further increased to an average of about 19% (with a 90% confidence interval from 7% to 33%). These results are situation specific. The gains could be greater if the volatility of the portfolio increases, the length of the horizon (and number of possible recharacterizations) increases, future tax rates are higher, the owner uses multiple portfolios, and the owner pursues an optimal strategy. Of course, the gains are reduced by opposing circumstances.

Conceptually, there is little downside risk associated with using the recharacterization option unless the owner forgets to recharacterize when he should. Absent such errors, the recharacterization option is a free option (except for paperwork) that has considerable value. Individuals in the United States have several trillion dollars saved in traditional IRAs, 401(k)s, and other such vehicles. The recharacterization option promises to be a valuable wealth management tool for many individual investors, materially enhancing their retirement wealth.