Myth: It’s Always Best to Consolidate Your IRA Accounts to Lower Fees

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Posted Feb 09

Normally, that is true. Most- and I use that word accurately -investors create the illusion of asset diversification by having multiple fund companies or even multiple IRA custodians. But there is so much overlap that the whole shebang is at risk anyway: twenty virtually identical large cap funds held by 5 different fund families still leave you flapping in the breeze of Wall Street hot air. And those unnecessary duplicated fees add up, especially in down or flat markets. So, yes, usually it’s a good idea to consolidate as much as possible to reduce or even eliminate fees.
Except in years 2010+. If you earn over $100,000. And are doing a Roth conversion. That’s because of a little known provision called “re-characterization”. Here’s why. Suppose your Traditional IRA is currently worth $100,000 and you decide to convert the whole thing to a Roth in 2010. The entire amount is taxable as ordinary income, but, you get to spread that out over two years. Your tax bill is, let’s say, $19,000 each year.
This winter, the market crashes. Again. Your new Roth is only worth $60,000 now. So your effective tax rate is 38/60 or 63%! Oops. Conversion was a bad idea. Well, you can “re-characterize” back to a Traditional IRA at $60,000 & then re-convert to a Roth, thereby reducing your tax hit to $11,400 per year, a savings of $15,200. Cool.
But what if some of your funds did really well? Doesn’t matter. You have to re-characterize the whole account.
Therefore, it would make sense to convert to several Roth accounts, each in a different asset class according to the Asset Allocation model you and your adviser designed. Then you get to keep the gainers and re-characterize only the losers.
Sounds more complicated that it is. Easy to do, pays big dividends.