If you’re going to convert a traditional IRA to a Roth IRA, you’ll lower your income tax if you segregate assets first.
Conventional conversion. John Smith has $200,000 in his traditional IRA. He has $100,000 in a domestic stock fund and $100,000 in a foreign stock fund. He owes tax on $200,000 of income when he converts.
Sophisticated conversion. Suppose John had set up a domestic Roth IRA with $100,000 and a separate $100,000 Roth IRA for the foreign fund. A year after the conversion, the domestic Roth IRA is up to $125,000 while the foreign Roth IRA is down to $75,000.
After a Roth IRA conversion, you can recharacterize (reverse) the conversion any time up to October 15 of the following year. In this example, John can recharacterize the foreign Roth IRA while leaving the domestic Roth IRA in place. He’ll owe income tax on a $100,000 conversion, not a $200,000 conversion.
If John had simply done one $200,000 conversion, recharacterization would not have been as effective because you’re not allowed to simply pull out your losers. When you convert to a Roth IRA, there are many ways you can separate your Roth IRAs, by market sector or asset class.