Research and Writing for Professionals


Roth Conversions - February 2010

In 2010 and future years individuals without being limited by the prior $100,000 gross income cap can convert funds from a regular IRA to a Roth. Income taxes are paid on the amount converted.

The benefits of a Roth are:

Minimum distributions are not required in one’s lifetime (Good for individuals who don’t need their IRAs to provide retirement income.) Heirs are required to follow the same schedule as for a regular IRA.

Qualified distributions from the Roth are made tax free.

Having both Roth and regular IRA permits flexibility in controlling how much of distributions are taxable versus tax free.

Diversifies holdings should Congress change tax laws on IRAs or Roths.

The primary cost of the conversion:

Conversion is a taxable event. For conversions in 2010 only, individuals have a choice of paying taxes either in 2010 or deferring them until 2011 and 2012 with the income being split evenly between the two years. The distributions will be taxed at the individual’s rate which includes the amount converted. Conversions in years after 2010 are not eligible for this special deferral.

Medicare Part B rates may increase for some individuals because of the higher taxable income that they report. (A reason to make the conversion before somebody goes on Medicare.)

Analysis

There is no simple general rule on whether to convert.

Current tax rates versus expected future tax rates, including those for heirs, should be considered.

You probably should not convert if you (or your heirs) later will be in a lower tax bracket.

If you or your heirs will likely be in a higher tax bracket when distributions are made, conversion makes more sense.

For an individual with a large estate, paying the income taxes now and passing the smaller estate to heirs will likely save estate taxes.

Needs for cash distributions should be considered.

Anyone temporarily in a low tax rate should consider converting as a way to utilize their low tax rate.

Someone anticipating paying large medical costs in the near future should not convert as the large medical costs could be used to offset IRA distributions in that year and this becomes a tax efficient way of removing assets from an IRA. Someone expecting to eventually leave an IRA to charity should not convert.

If converted, taxes should probably be paid in 2010 rather than being split with 2011 and 2012 to avoid possible Congressional tax increases in 2011 and 2012. However, paying the taxes loses the time value of money.

A client’s accountant should be asked to run estimates of what the taxes will be to take into account the complexities (impact of the AMT in particular) of the federal and state tax codes.

Special Planning Opportunity through Recharacterization

Regulations permit a Roth conversion to be cancelled (recharacterized) by October 15 of the year following the year in which the conversion was made. For example, a conversion made in 2010 can be recharacterized until October 15, 2011. This should be considered so an individual does not pay taxes on a conversion where the underlying investment subsequently drops in value.

Roth regulations permit multiple conversions.

Recommendation: Where appropriate, create multiple Roth’s. Fund each with a volatile investment that has a low correlation with the investments in the other Roth’s. The conversions could be spaced over time to potentially benefit from stock market fluctuations. Before the October 15 deadline recharacterize those Roth’s that have not performed well. Keep those that have done well. After the recharacterization deadline, Roth’s would be merged and turned into diversified portfolios. The delayed date for recharacterizations provides the individual flexibility and the ability to change one’s mind using information that may become known at a later date.

Note:
Unless certain criteria are met, Roth IRA owners must be 591/2 or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount is subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Please note, changes in tax laws or regulations may occur at any time and could substantially impact your situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS we are not qualified to render advise on tax or legal matters.


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