High Volatility, Negative Correlation, Roth IRA Conversions, and the Codified Economic Substance Doctrine

Abstract

This paper describes and analyzes an investment strategy that, when combined with simple Roth IRA conversion planning, can substantially reduce the tax costs of Roth conversions. The strategy leverages, through the combination of volatily and negative correlation, the put option feature inherent in Roth IRA recharacterizations. The only significant risk to taxpayers who execute the strategy is that the IRS might assert that the recently codified economic substance doctrine (and its strict liability penalty) applies to disallow the tax benefit. However, the doctrine appears not to be relevant in this context, where Congress has given taxpayers an explicit election to recharacterize Roth IRA conversions. Even if the doctrine were to apply, it would not likely increase current year tax liability.