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When One Roth IRA Is Not Enough

If you've finally decided to pull the trigger on a Roth IRA conversion, the simplest approach is to transfer assets from your traditional IRAs into a single Roth account. But you might instead consider setting up multiple Roth accounts to help insulate your savings from fluctuating markets.

This strategy depends on the rules for Roth "recharacterizations," in which you reverse a conversion to put your money back in traditional IRAs. With multiple Roth IRAs, you can recharacterize selected accounts if particular investments go south.

With a conversion to a Roth IRA, you pay taxes now to avoid them later; most distributions you take after you've reached age 59½ from a Roth you've had for at least five years are 100% tax-free.

Another advantage of a Roth is that if you don't want to take out money during your lifetime, you don't have to. There are none of the required minimum distributions (RMDs) that apply to traditional IRAs.

The trade-off for these benefits is that you must pay tax on the amount you convert to a Roth, just as if you had taken the money out of a traditional IRA for a normal distribution. You're taxed on the value of the assets you convert on the date of the conversion.

And what if that value declines after the conversion? You could end up paying taxes on assets that essentially have disappeared. That's where recharacterizations come in. The deadline for recharacterizations is your tax return due date for the year of the conversion plus any extensions. Thus, you have until October 15, 2018, to recharacterize a Roth conversion you make in 2017.

But you can't recharacterize part of a Roth IRA; you have to move the entire contents back into a traditional account. That's why it could make sense to set up multiple Roth accounts, with each one holding a different kind of asset.

Suppose you have $500,000 in your traditional IRAs, with $250,000 invested in stocks and $250,000 is in bonds. (This is hypothetical and not indicative of any particular allocation.) If the value of the stocks drops to $200,000 and the value of the bonds rises to $275,000, your entire account will be worth $475,000. If you recharacterized the account you could avoid paying taxes on that $25,000 of lost value ($500,000 - $475,000).

But consider what would happen if you set up two Roth IRAs—one for stocks and the other for bonds. Then, if stock prices fell, you could decide to recharacterize only the stock account. That would save you tax on $50,000 ($250,000 - $200,000), while preserving the $25,000 increase in the Roth invested in bonds.

Your financial situation may have other elements that would affect this strategy. But in the right cases it can add flexibility and protection with minimum risks.