Important Note: Due to tax code changes that were introduced by the Tax Cuts and Jobs Act of 2017, this strategy is NO LONGER VALID! Please see this post for more information on how the new tax legislation affects this and other early retirement tax avoidance strategies.
I have a strategy the guarantees you’ll make a fortune betting on horse races.
It’s very simple, actually. The idea is you bet a certain amount of money (x) on the horse that is favored to win. If the horse wins, great! You walk away with x and you can go home happy.
If the horse loses, however, you have to bet 2x on the next race’s top horse. If that horse wins, you’ll win back what you lost in the first race and you can go home with x winnings. If the horse loses, you’ll have to double your bet again and continue doing that until you eventually win.
The favored horse has to win eventually so this strategy guarantees you’ll walk away with x. Just make sure x is big enough so that you can retire as soon as you win that race!
Don’t Do That
Since you are a Mad Fientist reader, and are therefore one of the smartest people on the internet, you probably realize the strategy I just described shouldn’t be taken seriously. In order to guarantee success, you’d need to have an extremely large amount of capital to deal with the inevitable long string of losses.
There is one type of horse race, however, that can save you some money even if you don’t have a bottomless bank account.
Roth IRA Conversion Ladder
I’ve spoken frequently about Roth IRA Conversion Ladders because they allow future early retirees to take full advantage of tax-advantaged accounts and access the money in those accounts prior to standard retirement age (check out this post and this post for more info). Roth IRA Conversion Ladders are the main reason I’ll be able to Retire Even Earlier so they are an important part of my own personal plan.
Today, I’m going to describe an advanced strategy that you can use to supercharge your conversion ladder – the Roth IRA Conversion Horse Race.
Roth IRA Horse Race
When you convert from a Traditional IRA to a Roth IRA, you have the option of undoing the conversion before you file your tax return (this is called a Roth recharacterization). That means, you could execute the conversion in January and then rewind the conversion by April 15th of the following year (or October 15th, if you file an amended return) and the IRS treats it as though the conversion never happened.
To explain how we can use this to our advantage, let’s explore an example…
Suppose you just quit your full-time job and want to start building your Roth IRA Conversion Ladder. You expect to only use qualified dividends and long-term capital gains for income during your first year of retirement so that means you have $10,000 of tax space you can use for a completely tax-free conversion (the standard deduction and personal exemption amounts for 2014 add up to more than that but I’ll just use $10k to make the numbers cleaner).
For simplicity, assume your Traditional IRA consists of an equal amount of Total Stock Market and Total Bond Market index funds. To start building a normal Roth IRA Conversion ladder, you’d just convert $10,000 of your balanced portfolio to your Roth IRA ($5,000 of Total Stock Market and $5,000 of Total Bond Market).
To build a Roth IRA Horse Race, you’d instead do two different conversions into two separate (and empty) Roth accounts. So in this example, you’d convert $10,000 worth of Total Stock Market index fund into it’s own Roth account and $10,000 worth of Total Bond Market index fund into a separate Roth account (segregating the funds like this will make the recharacterization process much easier). This will result in converting twice as much as you would actually like to convert for the year.
Assume that after building the Roth Horse Race at the beginning of year one, the two different Roth account balances in April of year two are as follows:
Total Stock Market – $18,000
Total Bond Market – $6,000
To maximize the value of the conversion, you would keep the Total Stock Market account and recharacterize the Total Bond Market account. This would allow you to get $18,000 of funds converted for the “price” of $10,000. Had you simply converted your entire portfolio, you’d only have $12,000 in your Roth by April of year two ($9,000 Total Stock Market and $3,000 of Total Bond Market).
What if the Total Bond Market fund also grew significantly?
Total Stock Market – $18,000
Total Bond Market – $14,000
You may find it worthwhile to keep both Roth conversions and take a small tax hit (since you’d only be paying tax on the extra $10,000 of conversion but you’d be getting an extra $14,000 into your Roth).
Obviously you couldn’t have predicted what the market was going to do back in January of year one, so you wouldn’t have thought to double your Roth conversion, but now that you’ve seen how the market has performed, having a Roth Horse Race gives you the option to convert more.
What if the market tanks and both of your funds actually decrease?
Total Stock Market – $6,000
Total Bond Market – $9,000
You may decide to recharacterize both of the Roth accounts and instead use the tax-free space you have available to tax-gain harvest instead (note: you’d have to make this decision before the end of the calendar year, since you wouldn’t be able to wait until year two to harvest your gains).
I realize some of you may feel the additional hassle of recharacterization isn’t worth it but for those of you who want to get as much of their money converted into a Roth as quickly and cheaply as possible, a Roth Horse Race could be a great way to accomplish that.
What do you think? Do the benefits outweigh the potential hassle?