January 2010

What you need to know about Roth IRA Conversions

Author: Lew Wessel | Photographer: Anne

TRUST ME! I know this month’s topic seems a bit narrow and technical, but it is actually the hottest tax and personal financial planning issue of 2010. Expect, starting January 1, to be inundated with newspaper articles, mailings and even direct phone calls urging you to “convert.” Here’s what you need to know:

TRADITIONAL IRA VS. ROTH IRA

The Traditional IRA account was first authorized in 1974 with the Employee Retirement Income Security Act (ERISA). It is a special tax-favored account, designed to help taxpayers save for retirement. Two key attributes of the account are:
a) The taxpayer reduces his/her adjusted gross income (AGI) by the amount of the contribution made to the IRA, so that there is an immediate tax savings; and
b) Earnings from investments in the account grow tax-free until distributed, so that, with compounding, the investments grow significantly faster than in a taxable account.

Once you begin to take your money out to live on during retirement, EVERYTHING that comes out of the IRA is taxed—for the first time—at ordinary income rates.

The Roth IRA, first conceived in 1997 and appropriately named the “American Dream Savings Account,” is also a tax-favored account and shares many attributes of the traditional IRA, but is different in two critical ways:
a) The taxpayer does not reduce his/her AGI by the amount of the contribution made to the IRA, so that there is no immediate tax savings; and
b) Earnings grow tax-free, as in a traditional IRA, but, unlike the traditional IRA, they are NEVER taxed.

Cutting to the chase, the difference between the Traditional IRA and the Roth IRA is that the former gives you an immediate tax deduction but eventually taxes all contributions and earnings; with the Roth IRA, there is no immediate tax benefit. The original contribution is with after-tax dollars, but, in return, earnings are never taxed.

THE ROTH CONVERSION

The ability to “convert” an existing Traditional IRA into a Roth IRA has been around since the birth of the Roth IRA. The basics of a “conversion” are that the taxpayer moves all or part of his/her Traditional IRA into a Roth IRA and adds the amount that has been moved to his/her taxable income in the year of the conversion. From the date of the conversion onward, the account is now a Roth IRA and thus will never be taxed again, even when amounts are later taken out of the account at, say, retirement. Up until the end of 2009, “conversions” were only available to those taxpayers, single or joint filers, with adjusted gross incomes (AGI) under $100,000.

Starting January 1, 2010, The Tax Increase Prevention and Reconciliation Act of 2005 (“TIPRA”) eliminates the $100,000 conversion ceiling, opening up the conversion possibility to all taxpayers. In addition, to sweeten the deal even more, TIPRA allows for a one-time election, for those converting in 2010 ONLY, to add one-half of the converted amounts to their 2011 and 2012 returns instead of having to stack it all on top of 2010 taxable income.

Why is this such a big deal? Beyond the obvious point that millions more working taxpayers will now be eligible to make a “conversion,” affluent retirees who have rolled their large 401K’s into equally large Traditional IRA’s now have an option to convert these savings to Roth IRA accounts and thus significantly change their retirement income and estate planning situation.

DECISION FACTORS

Before we get into the details, keep in mind that the essence of the “conversion” decision is simply whether to pay taxes now or later on the amounts in your IRA account. Convert to a Roth: Pay NOW. Don’t Convert: Pay LATER.

Time Value Of Money: A general rule of finance is that a dollar today is worth more than a dollar tomorrow due to inflation and other risks. Therefore, as a general rule, one would rather pay taxes later than sooner. This general rule obviously favors NOT converting. Having said that, there are so many other factors involved, many favoring the Roth Conversion, that this general rule becomes just one more complicating factor that must be included in your Conversion Calculator (see below).

How Taxes Are Paid: A good rule to follow is that, if you do a conversion, pay the additional taxes that will result from the conversion with funds NOT inside your traditional IRA. This will allow the full amount to roll forward and increase the non-taxable distributions you will have in the future.

Tax Rates Now VS. Future Tax Rates: If you believe tax rates will be higher in the future, this favors a conversion and, perhaps, NOT deferring the resulting taxable income increase to 2011 and 2012. With the sun-setting of “the Bush tax cuts” in 2011 and with a large national debt to pay off, it’s a pretty good guess that tax rates will be higher down the road.

Your Own Current Marginal Tax Bracket VS. Your Future Marginal Tax Bracket: This is really the key issue and not nearly as simple to determine as general tax rates. Even if you are “sure” that the top tax rate is going to 39.6 percent or higher, that doesn’t mean your marginal rate will be that high. Often, during retirement, taxable income decreases along with that marginal rate.

Another factor to keep in mind here is that if you convert a large sum, you may move yourself right into an alternative maximum tax (AMT) situation which is a whole other ball of wax.

Your Future Income Needs: A key advantage of Roth IRA’s is that there is no minimum required distribution (MRD) after age 70½, as there is with a Traditional IRA. Thus, if you don’t need to use your IRA savings for all your income as you grow older, a conversion may add tremendous flexibility to your financial plans.

Estate Tax Issues: Similarly, if you want to leave a tax-free lifetime income stream to your heirs, converting will clear the way to do just that. In addition, by converting and paying the income taxes now, you will remove dollars out of your taxable estate.

Investment performance: You only pay tax on the amount you convert, so, if the portfolio inside your Traditional IRA has taken a beating in the past couple of years, you can make a little lemonade out of those lemons by converting now when your portfolio value is low. Once converted to a Roth IRA, your portfolio will be poised to hopefully recover to its pre-slump values, this time tax-free.

STRATEGIES

There are some VERY sophisticated strategies involved with conversions that excite the heck out of a room full of CPA’s like me. At the heart of these strategies is the fact that conversions can be legally undone and then redone, over and over and over (with some timeline restrictions).

As an example, let’s say I do a conversion of an IRA of $200,000 on January 1, 2010. At this point, because of the conversion, I will have to add $200,000 to my taxable income for 2010, or, if I make the one-time special election described above, $100,000 each to my taxable income for 2011 and 2012. Let’s further suppose that the stock market immediately tanks and by November, 2010, my portfolio, now in a Roth IRA, has sunk to $100,000. This is a horrible situation since not only have I lost $100,000 in my portfolio, but since I converted earlier in the year, I am stuck with recognizing $200,000 in income on my 2010 return. Or am I? Believe it or not, current tax law allows me to “recharacterize,” or completely reverse, my conversion. This is, of course, exactly what I do, leaving me, once again, with a Traditional IRA, now worth $100,000 and NO additional taxable income for 2010. I’ve still lost $100,000 in my portfolio, but at least I don’t have a tax hit as well. A good deal? You bet! But wait, there’s more. In January of 2011, I can “reconvert” my Traditional IRA into a Roth IRA. The difference is that this time I only have to add to my taxable income the current $100,000 value. This cycle: convert-recharacterize-reconvert can be done over and over until you finally get your money into a Roth IRA with the optimum tax result.

Should you or shouldn’t you convert, and, if so, how much? As discussed above, there is no simple answer. You’ve got to run the numbers on this one. Every factor mentioned above, particularly your assumptions concerning tax rates, return on investment and withdrawal schedules will have a dramatic effect on the bottom-line. Fortunately, along with your tax professional, there are literally thousands of on-line sites with “Roth conversion calculators” that can help you come to a sound decision.

A FINAL CAVEAT

I have not covered here some of the complicated and tricky rules as well as very specific timelines and procedures involved with conversions, recharacterizations of conversions and reconversions that must be followed in order to avoid a potential financial disaster. In addition, since each step must be done as a trustee-to-trustee transfer, you must make sure you coordinate properly with your trustee (e.g. bank, brokerage firm, etc.) I urge you, as always, to consult with a tax professional as you pursue this very powerful tax planning tool in 2010 and future years.

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