Author Topic: Extreme Roth IRA Horse Race  (Read 6441 times)

climber1

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Extreme Roth IRA Horse Race
« on: March 30, 2015, 07:10:31 PM »
I am a big fan of using legal tax-avoidance to bring FI even closer. Particularly, taking advantage of the various tax-advantaged accounts to the maximum extent. I recently read Mad Fientist's post "Roth IRA Horse Race" (http://www.madfientist.com/roth-ira-horse-race/)which describes a strategy to reduce your tax burden on conversions from a Traditional IRA to Roth IRA. However, I think it can be even better than he describes! If my idea is correct, it should be possible to convert a Traditional IRA to Roth IRA while paying effectively no tax! However, I am no CPA, so wanted to get feedback from others here who might have taken advantage of some of various tax-avoidance methods.

In his post, Mad Fientist describes making two Traditional IRA -> Roth IRA conversions one into a Total Stock index and other into a Total Bond index and then keep whichever does better. The expectation is that the performance of the two is uncorrelated or inversely correlated. So my thought was why not take this to its logical extreme by investing the two Roth IRAs in assets which are perfectly anti-correlated.

For instance, you convert $10,000 into each. Then, you invest each $10,000 into opposite sides of the same binary option which has even odds. To give a more clear example, maybe one is betting that Intel stock is above $32 at end of day tomorrow and the other is betting the opposite.

Then, when the options close, one Roth IRA ends up on the right side of the option and has $20,000 and the other has $0. You recharacterize the one with $0 back to a traditional IRA. So now you have moved $20,000 from your Traditional IRA to your Roth IRA while only paying tax on $10,000. Yay!

To extend the idea further, there is no reason to stick to only 2 Roth IRAs. Imagine you have N of them and want to move $100,000 to your Roth IRA. You move $100,000/N into each, do the above, but with an option with N outcomes each with the same odds. One account ends up with $100,000 and the other all have $0 and are recharacterized by to traditional IRA. So, you only pay tax of $100,000/N. By taking N large enough, you can basically pay no tax.

The downside of doing this is that most of the money which ends up in your Roth IRA account is considered as earnings since from the IRS's perspective, you converted $100,000/N and now have $100,000. This doesn't matter if you don't need to withdraw until age 59.5 since you won't pay tax on the earnings. On the other hand, if you need the money sooner, you would end up paying ordinary income tax plus the 10% penalty. This is worse compared to just doing the normal Roth IRA conversion ladder (since after 5 years you pay no tax on withdrawal of the converted amount). However, it is no worse than just withdrawing directly from the traditional IRA.

So I think this proposal lets you never pay tax on amounts that you currently have in a traditional IRA or 401k as long as you don't need them until after 59.5. What do you think?

bacchi

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Re: Extreme Roth IRA Horse Race
« Reply #1 on: March 30, 2015, 09:24:26 PM »
It sounds like a wash trade, which is illegal. You can't be long and short with the exact same instrument.

Edit: Or, if not illegal, the loss can't be used.

climber1

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Re: Extreme Roth IRA Horse Race
« Reply #2 on: March 30, 2015, 10:04:51 PM »
It sounds like a wash trade, which is illegal. You can't be long and short with the exact same instrument.

Edit: Or, if not illegal, the loss can't be used.

Wash sales result in losses not being deductible. This generally applies to taxable accounts. I don't see what impact this could have on IRAs where you pay no capital gains tax.

Singularity

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Re: Extreme Roth IRA Horse Race
« Reply #3 on: March 30, 2015, 10:12:31 PM »
Interesting idea.  What are the option limitations in IRA accounts and what broker is this allowed at?

climber1

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Re: Extreme Roth IRA Horse Race
« Reply #4 on: March 30, 2015, 10:37:45 PM »
I am not aware of any limits on investing in options in an IRA (though IANACPA). You are correct that the companies which Mustachians typically hold their IRAs at don't generally offer this opportunity. That isn't surprising as option investing is generally high risk and not something most investors should be doing with their retirement savings. This is an odd case as there is no actual risk (other than from the IRS calling BS). At the very least, you should be able to invest in options through a self-directed IRA.

johnny847

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Re: Extreme Roth IRA Horse Race
« Reply #5 on: March 30, 2015, 11:21:45 PM »
It sounds like a wash trade, which is illegal. You can't be long and short with the exact same instrument.

Edit: Or, if not illegal, the loss can't be used.

Wash sales result in losses not being deductible. This generally applies to taxable accounts. I don't see what impact this could have on IRAs where you pay no capital gains tax.

Agreed, wash sales have nothing to do with this.


I want to sleep on this, but it all seems right to me. With one minor comment. You don't need your outcomes to have the same odds. In your simple example, it doesn't matter if the Intel stock closing about $32 is 90% likely or 50% likely. As long as you place both bets, one of your IRAs will be up and one of your IRAs will be down.

climber1

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Re: Extreme Roth IRA Horse Race
« Reply #6 on: March 30, 2015, 11:37:04 PM »
With one minor comment. You don't need your outcomes to have the same odds. In your simple example, it doesn't matter if the Intel stock closing about $32 is 90% likely or 50% likely. As long as you place both bets, one of your IRAs will be up and one of your IRAs will be down.

You are right that they don't need to have the same odds, but you need to take positions accordingly. So if you are handling $100,000, you put $90,000 on the outcome which is 90% likely to occur, which will pay out 100/90=1.11X times for a total of $100,000 if that outcome occurs, and $10,000 on the outcome which is 10% likely to occur as it will pay out 100/10=10X for a total of $100,000 if that occurs instead. So either way you end up with $100,000 in one account and $0 in the other.

But this also results in the amount you have to pay tax on depending on chance. If you recharacterize back the $10,000 account, you pay tax on the $90,000. Vice versa, if you recharacterize back the $90,000 account, you pay tax only on the $10,000. Even odds makes in a guaranteed $50,000. Of course, this gets even better if you increase the number of Roth IRAs in use.

So I think using even odds would just make it easier.

johnny847

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Re: Extreme Roth IRA Horse Race
« Reply #7 on: March 31, 2015, 12:31:32 AM »
With one minor comment. You don't need your outcomes to have the same odds. In your simple example, it doesn't matter if the Intel stock closing about $32 is 90% likely or 50% likely. As long as you place both bets, one of your IRAs will be up and one of your IRAs will be down.
So I think using even odds would just make it easier.

That's exactly my point. You don't need to use something that has even odds.

StreetCat

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Re: Extreme Roth IRA Horse Race
« Reply #8 on: March 31, 2015, 11:32:39 AM »
Hello Mustachians, this is my first post and I've been lurking for around a year now.  You all have a really good forum going on here.

About climber1's idea of using options, I *think* I understand what is being suggested.  But, buying opposite sides of options that way (either a straddle or a strangle) will expose you to time decay on both sides.

In other words, if you buy at-the-money (ATM) call and ATM put, then by the expiration date one of them may go up and the other may go down (unless the stock remains at the same level as when the options were purchased, in which case the calls/puts may not go up in value at all).  But all the time from option purchase to option expiration, both option sides are losing money due to time decay.

So, unless the stock moves a lot, won't that cause an overall loss to both Roth accounts?

dandarc

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Re: Extreme Roth IRA Horse Race
« Reply #9 on: March 31, 2015, 12:27:47 PM »
Where can you trade binary options?  That also offers an IRA?

Or was that just a hypothetical example?

StreetCat

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Re: Extreme Roth IRA Horse Race
« Reply #10 on: March 31, 2015, 02:29:38 PM »
Oops... I didn't realize that binary options are a different class of options.  Found a list of brokers online: http://www.binaryoptions.com/brokers/

I couldn't recognize any names in that list, and it looks like the regulated brokers do not allow US clients.

dandarc

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Re: Extreme Roth IRA Horse Race
« Reply #11 on: March 31, 2015, 02:38:17 PM »
Looking at that list - a lot of them offer bonuses for depositing money.  Advertising a payout percentage?  This looks less like an investment and more like online gambling.

Regardless, even assuming we can find a broker to make these trades, there is a cost.  Note that payout percentage seems to cap at 90%.  So to even place these off-setting bets, you're going to either lose 10% to the comission, or take some timing risk hoping you can get the prices for both the call and put at the right level.  Price could move the wrong way on you.

Is there another vehicle that might make practical sense here?  Maybe the leveraged and inverse ETF ideas - buy both in the morning, sell at close?  Probably not going to get one of the ETFs to zero completely, but you can maybe manufacture the large swing in the accounts you need to pull this off?

climber1

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Re: Extreme Roth IRA Horse Race
« Reply #12 on: March 31, 2015, 05:47:01 PM »
I am sorry for the confusion caused by me suggesting binary options. It made the explanation a lot easier and I didn't have any reason to think they didn't exist. I did some further research and it looks like the market for binary options is highly illiquid and somewhat sketchy. Clearly there is a gap between knowing the theory of mathematical finance and the actual practice of it in the real world.

However, it doesn't invalidate the whole idea. You should still be able to take opposing positions in some asset. In practice, IRAs probably won't allow naked shorts so you need a position which has a maximum potential gain and loss. A collar option would work. Basically, you have a long call option at one strike price and a short call option at a different strike price. Also, you would lose some money on the bid-ask spread, but many option markets are very liquid so this should be small (and the tax savings should be well worth this cost).

I think the real question is whether this is legitimate in the eyes of the IRS. We can work out all the details of the implementation, but if the IRS considers it illegal, then it isn't worth anything.

StreetCat

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Re: Extreme Roth IRA Horse Race
« Reply #13 on: March 31, 2015, 05:48:46 PM »
Is there another vehicle that might make practical sense here?  Maybe the leveraged and inverse ETF ideas - buy both in the morning, sell at close?
That's an interesting idea.  Leveraged/inverse ETFs have decay issues, but buying at open and selling at close should bypass those issues.  What about commissions with that strategy?  If you are buying/selling everyday, lot of money will be spent on commissions, right?  If the amount you move into Roth is big enough, it may not matter though.

The other thing I was thinking about was to buy deep in-the-money calls and puts and wait for 1+year.  That will give the underlying stock time to make a large move, and it is also leveraged (you can control the degree of leverage by selecting the appropriate strike prices on either side).  But this scheme is also not without its flaws.  You will end up paying at least the risk-free interest rate for ITM options, possibly a bit more than that.

dandarc

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Re: Extreme Roth IRA Horse Race
« Reply #14 on: March 31, 2015, 07:02:35 PM »
Is there another vehicle that might make practical sense here?  Maybe the leveraged and inverse ETF ideas - buy both in the morning, sell at close?
That's an interesting idea.  Leveraged/inverse ETFs have decay issues, but buying at open and selling at close should bypass those issues.  What about commissions with that strategy?  If you are buying/selling everyday, lot of money will be spent on commissions, right?  If the amount you move into Roth is big enough, it may not matter though.

The other thing I was thinking about was to buy deep in-the-money calls and puts and wait for 1+year.  That will give the underlying stock time to make a large move, and it is also leveraged (you can control the degree of leverage by selecting the appropriate strike prices on either side).  But this scheme is also not without its flaws.  You will end up paying at least the risk-free interest rate for ITM options, possibly a bit more than that.
I think the point is to make this as close to a one-time event as possible - not any sort of investing strategy.

Not sure there's anything beyond 3X available in leveraged ETFs, and margin is prohibited in IRAs, so it would be hard even with that leverage to get enough of a swing to make a difference in one day.  And holding beyond one day, as you point out is a fools errand.  So that was a bad idea by me.

The binary option is, I think the best choice theoretically for this - if you can buy both sides at $50 it accomplishes the goal - one of the 2 will win and be worth $100, and the other will be worth $0.  But yet to find anywhere that will let you do this with an IRA.  Then you're saving taxes but possibly paying high fees.

climber1

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Re: Extreme Roth IRA Horse Race
« Reply #15 on: March 31, 2015, 07:48:08 PM »
I think the point is to make this as close to a one-time event as possible - not any sort of investing strategy.

Not sure there's anything beyond 3X available in leveraged ETFs, and margin is prohibited in IRAs, so it would be hard even with that leverage to get enough of a swing to make a difference in one day.  And holding beyond one day, as you point out is a fools errand.  So that was a bad idea by me.

The binary option is, I think the best choice theoretically for this - if you can buy both sides at $50 it accomplishes the goal - one of the 2 will win and be worth $100, and the other will be worth $0.  But yet to find anywhere that will let you do this with an IRA.  Then you're saving taxes but possibly paying high fees.

So I cross posted this question to Bogleheads to get some other opinions, https://www.bogleheads.org/forum/viewtopic.php?f=2&t=162433. In my most recent reply, I ran through some actual numbers to look at what you might lose to the spread. Reproduced below:

Here is a quick example based on current prices for May 2015 call options on the S&P 500. The current bid and ask on call options with a strike of $2040 is $62.20 and $62.80. The current bid and ask on call options with a strike of $2095 is $26.60 and $27.20. We will look at collar options with strike prices of $2040 and $2095.

You transfer $36.20 to one Roth IRA and buy a call option at strike $2040 and sell a call option at strike $2095. The net premium of these options is the whole $36.20.

You transfer $20.00 to another Roth IRA and sell a call option at strike $2040 and buy a call option at strike $2040. This nets you premiums of $35.

Then, at expiry, if the price is below $2040, the first account ends up with a balance of $0 and the second with a balance of $55. If the price is above $2095, the first account ends up with a balance of $55 and the second with a balance of $0. If the price, P, is between the two, then the first account has a balance P-2040 and the second a balance 2095-P. So in any case, you end up $55 in total (the other $1.20 was lost to the bid-ask spread). Now, if you did end up in the intermediate region, you need to repeat again. Ideally, you use a high volatility underlying asset to reduce the chance of this.

Overall, this gets $55 into the Roth IRA with a tax on either $36.20 or $20. So in the worst case, you lost $1.20 on the spread to reduce taxable income from $56.20 to $36.20. This is 6% ($1.20/$20). That is better than my tax bracket and this was literally the first example I could find. I am sure with a little more digging I can find something with a smaller spread (currencies would be my first guess).

dandarc

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Re: Extreme Roth IRA Horse Race
« Reply #16 on: March 31, 2015, 08:05:27 PM »
So I don't think you can naked sell options in an IRA.

http://sixfigureinvesting.com/2012/11/top-15-questions-about-trading-in-an-ira/

climber1

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Re: Extreme Roth IRA Horse Race
« Reply #17 on: March 31, 2015, 08:14:47 PM »
There is no naked short in this proposal. In order for it to be a naked short, you must have an infinite potential loss. This is what would happen if you just sold a call option. If the stock price when to infinity, then you would have an infinite loss. However, by also holding a long call option at a different strike price, you limit your potential loss. The limit depends on the difference between the strike prices of the long and short options.

dandarc

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Re: Extreme Roth IRA Horse Race
« Reply #18 on: March 31, 2015, 08:24:58 PM »
Forgot about the extra $20 in that second account.  Sorry.

dandarc

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Re: Extreme Roth IRA Horse Race
« Reply #19 on: March 31, 2015, 08:39:41 PM »
So the risk is that the price stays flat and you've paid that spread and have to try again?

And this comes with the upside that maybe both positions pay off by the expire date.

climber1

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Re: Extreme Roth IRA Horse Race
« Reply #20 on: March 31, 2015, 08:55:17 PM »
So the risk is that the price stays flat and you've paid that spread and have to try again?

And this comes with the upside that maybe both positions pay off by the expire date.

Yes, if the price does not change significantly, you might have to try again. So this is somewhat of an underestimate of cost. Ideally, you would take the two strike prices very close together so it is very unlikely that the price ends up between the two. The tradeoff of doing so (for instance, using strike prices of $2065 and $2070) is that the bid-ask spread becomes more significant relative to the difference between the price of the options. It would be a messy optimization problem to determine what strike prices result in the smallest expected percentage loss to the spread, but theoretically it shouldn't be difficult.

By the way, if doing this, it needs to be with European-style options, rather than American-style options. Early exercise would mess things up by causing the portfolio to become unbalanced unexpectedly.