Advanced Topics in Roth Conversions
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  • 5 Years for Roth: IN which conversion was made, or FOR which contribution was made

Advanced Topics in Roth Conversions Advanced Topics in Roth Conversions Presentation Transcript

  • Advanced Topics in Roth Conversions 9 Critical Issues for Real World Clients www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Welcome! An Overview of Our Schedule
    • Housekeeping, Introductions
    • Recapping “the basics”
    • Examples for typical client profiles
    • If only it were that simple – real world complications
    • Real world conversion: nine critical issues
    • Q & A
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Housekeeping
    • Break
    • Bathrooms
    • Parking
    • Continuing Education sign-in
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Introductions
    • SoundView Advisors
      • Firm profile
      • Target clients
      • Key values
    • Presenters Today
      • Kevin M. Rigg, CPA, CFP®
      • Ben L. Jennings, CPA/PFS, CLU, CFP®
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • A Brief History www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Traditional IRAs
    • ERISA (1974)
      • $1,500 Deductible Contributions
      • Only if not covered by an employer plan
    • ERTA (1981)
      • Eased restrictions
      • Raised max contribution to $2000
      • Spousal IRA ($250 for nonworking spouse)
    • Tax Reform Act (TRA-1986)
      • Reversed expansionary trend by phasing out deductibility
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Enter William Roth…
    • Born in Helena, Montana
    • Graduate of the University of Oregon (Eugene)
    • Harvard Business, Harvard Law
    • Worked as attorney for Hercules Corp in Delaware
    • House of Rep – 1967
    • 1970 – Began 5 terms in US Senate
    • Fiscal conservative, advocate of tax cuts
      • Co-authored 1981’s ERTA, which was also known as the Kemp-Roth Tax Cut
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • And in 1997 – Roth Turned The IRA Upside Down www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Vive la Difference www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • The “Traditional” IRA Getting Money In - Eligibility
    • Not covered by employer retirement plan?
      • May contribute for both spouses with full deduction
    • MFJ & covered by employer plan?
      • MAGI < $89,000 – May contribute, full deduction
      • MAGI > $109,000 – May contribute, no deduction
      • MAGI $89,000 - $109,000 – Deduction phase-out
      • Only one spouse covered?
        • Covered spouse deductibility same as MFJ
        • Non-covered spouse deductions phase out for MAGI between $167,000 - $177,000
      • Note: amounts different if single (phase-out $56-66k)
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • The Roth IRA Getting Money In – Eligibility
    • Contributory
      • Deduction?
        • Never!
      • Contribution? Eligibility Phases Out:
        • MFJ: $167,000 - $177,000
        • Single: $105,000 - $120,000
    • Conversion
      • Before 2010: MAGI <$100,000 (and not MFS)
      • Now & future: No income limits
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Getting Money In: Contribution Amount – Either Type
    • $5,000 per person
    • Additional “catch-up” contribution of $1,000 if you reach age 50 before the end of the calendar year
      • For 2010, this applies if you were born before 1961
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Distribution Distinctives Note: Roth IRA ≠ Roth 401k, etc.
    • Traditional IRA
    • Taxable as “ordinary” income (any basis reduces taxation)
    • RMDs during participant’s life
    • Ordering rules follow “cream in the coffee” rule
    • Roth IRA
    • Tax-free (if Roth open 5+ tax years, and >59.5)
    • No RMDs during participant’s life
    • Contributions first (then conversions, then earnings)
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Qualified Roth Distributions
    • Only qualified distributions are necessarily tax-free
    • Qualified distributions occur after
      • Five-year waiting period (after opening any Roth), and
      • Triggering event has occurred
        • Attained age 59.5
        • Died
        • Totally Disabled
        • “ First time” home purchase (distribution up to $10k)
      • Note that these are similar but not identical to the 72(t) requirements
        • Example: withdrawals to pay higher education expenses are not qualified
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • What if the distribution isn’t qualified? A: Turn to the “Ordering Rules” www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Roth Ordering Rules in Detail
    • All direct contributions are aggregated
    • Each “rollover” (conversion) contribution separately on FIFO basis for ordering & penalty rules
      • All conversions within same year are aggregated
    • Once all contributions have been distributed, the balance of the distribution comes out of earnings
    • Note: all distributions during the year are aggregated as one distribution at the end of the year
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Why do we care about the Ordering Rules?
    • Determines whether a “nonqualified” distribution is subject to income tax
      • Bottom line: distributions aren’t taxable until all contributions have been distributed
    • Also used in determining whether the 10% penalty applies to distributions from conversions
      • If ordering rules result in distribution allocable to a conversion and the distribution is made within the 5 taxable year period beginning with the first day of the taxable year in which the conversion contribution was made….
      • Then the 10% §72(t) penalty will apply to the distribution unless an exception applies
      • Note also that this penalty applies even though the distribution is not included in gross income in the year it occurs
        • Only case where you can owe a 10% penalty on an amount not includible in gross income
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Don’t be confused…. 5 Years ≠ 5 Years
    • The five-year period for determining exposure to the 10% penalty for distributions allocable to conversions is not the same as the five-year period for determining “qualified distributions”
      • Different reference point
        • 72(t): Year of specific conversion
        • Qualified Distribution: Year of any contribution
      • Different starting point
        • 72(t): Year in which
        • Qualified Distribution: Year for which
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • So to recap, just remember that a Roth creates two issues in one!
    • Two parts of the Roth
      • The contribution(s)
      • The earnings
    • Two types of distributions
      • Qualified
      • Nonqualified
    • Two taxes to worry about
      • Income tax
      • 10% 72(t) penalty
    • Two (completely different) five-year holding periods
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Let’s be clear: How about taxation of earnings in a Roth?
    • Nobody can withdraw the earnings from a Roth tax-free unless they meet both parts of a two-part test
      • Five-Year Holding Period (for any Roth IRA)
      • Triggering Event (at time of withdrawal)
        • Over 59.5
        • Totally disabled
        • Dead
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • The Old Switcheroo… Basic Principles Applicable to the Conversion Analysis www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • The Mathematics of Conversion: Part 1: It’s a Bracket Racket
    • A Roth conversion with the same current and future effective tax rate – paying the tax from the IRA itself – is tax neutral.
    • This goes back to the associative property you learned in 5 th grade (or earlier!)
    • Associative means you can group the numbers in any way without changing the answer
      • A X B X C = D
      • A X C X B = D
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Example www.SoundViewAdvisors.com Advanced Topics in Roth Conversions Traditional Roth Current Pre-Tax Balance $100,000 $100,000 Less: Conversion Tax @ 25% - (25,000) Current After-Tax Balance $100,000 $75,000 Assumed Growth 400% 400% Pre-Tax Balance (Yr 30) $400,000 $300,000 Less: Income Tax on Withdrawal @ 25% (100,000) - After-Tax Balance (Yr 30) $300,000 $300,000
  • The Mathematics of Conversion: Part 2: Diminishing Returns
    • Each additional dollar of a Roth conversion can only provide an equal or lesser benefit than the dollar immediately before it.
    • The lower the effective rate paid on the conversion, the greater the benefit.
    • “Less is more”
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • The Mathematics of Conversion: Part 3: Outside is Better
    • A Roth conversion – within the same tax bracket – using funds from outside the IRA to pay the tax – is tax favorable.
    • This is because you are keeping more funds within a tax-qualified environment.
      • The funds outside the IRA are experiencing “tax drag”
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • The Mathematics of Conversion: Part 4: Longer is Better
    • The longer the time frame until consumption of the funds, the better the result.
      • Even if the client may be in a lower bracket in the future, if
        • The client has outside funds to pay the tax, and
        • The funds will be able to grow in a tax-free environment for a long time
      • It’s possible a conversion would be beneficial.
      • Keep in mind that the time frame may appropriately include the time horizon until the beneficiaries would consume the funds
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • The Mathematics of Conversion: Part 5: Married is Better Than Single
    • Because married couples have lower rates than single taxpayers, Roth conversions in the current tax bracket will typically be desirable for couples over 65 or where there are longevity concerns.
      • This takes advantage of the couple’s joint tax rate being lower than a surviving spouse’s single taxpayer rate.
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • The Mathematics of Conversion: Part 6: Income Tax is Better Than Estate Tax
    • Income tax is tax-exclusive, but estate tax is tax-inclusive
      • I.e., you pay estate tax on the assets with which you’re going to pay the tax.
      • Converting and paying the income tax now removes the amount of the tax from the taxable estate
    • The §691(c) deduction (IRD deduction) helps mitigate the effect of double taxation
      • However, the taxpayer may not be able to take full advantage of the deduction
        • Not subject to 2% floor, but only available if itemizing
        • More importantly, the deduction is for federal estate taxes only and does not an allowance for state estate taxes paid
    • So, it’s more tax-efficient to incur an income tax before incurring an estate tax
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Mechanics of Conversion
    • 3 Methods
      • Distribution from traditional IRA is rolled over to a Roth IRA within 60 days
      • Direct plan-to-plan transfer between the T-IRA trustee (or custodian) and the R-IRA trustee
      • All or part of a T-IRA can simply be redesignated as a Roth IRA maintained by the same trustee or custodian
    • Each of these transaction is officially a “rollover”, but because that word is strongly associated with tax-free transfers between plans, the term “conversion” is a handy way to distinguish this.
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Frequency of Conversion
    • Generally, no limit on the number of times a client may convert traditional IRA funds to Roth IRA status
      • One exception: a client who did a Roth IRA conversion, then “unconverted” an amount (recharacterized) must wait (at least) until the tax year following the original conversion
    • The one-rollover-per-year limitation does not apply to a Roth conversion, so a conversion is allowed even if it is within 12 months of a tax-free traditional IRA-to-IRA rollover
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • The Do-Over: Recharacterization
    • Heads you win, tails you get to play again
    • Will discuss the mechanics of recharacterization in detail later in this presentation
    • Note that the client can also re-convert following a recharacterization
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Recharacterizations Must Include Attributable Income
    • Method 1: If the conversion
      • Was made to a separate Roth IRA that contained no other funds, and
      • There have been no other contributions to or distributions from that separate Roth IRA, and
      • The entire contribution is being recharacterized, then
      • We can simply transfer the entire account balance back to a traditional IRA
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Recharacterizations Must Include Attributable Income
    • Method 2: If method 1 is not available, the net income attributable to the conversion must be calculated by a (somewhat complex) formula
      • See Reg. §1.408-4(c)(2)(ii)
      • As will be discussed later, this is done on the basis of the entire account value, not of particular assets
    • Practice tip: keep each year’s Roth conversions in a separate Roth account (not commingled with any pre-existing Roths) until the period has expired for recharacterizing such conversions
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Who Wins? www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Key Factors -
    • Rates
    • Timing of distributions
    • Transfer taxes
    • Source of funds for tax payment
    • Interaction with broad financial situation
      • Early retiree
      • Charitable intent
      • NOL
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Roth Conversion Factors & Typical Client Profiles www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • The Young Couple
    • Key question : current versus future tax rates
      • Typical pattern of increasing income makes being in a higher bracket later more likely
      • Fiscal patterns also would seem to make higher future tax rates more likely
      • On the other hand, clients in this season of life also have a longer period over which tax policy can change
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Middle America Retirees
    • Key question : source of funds for payment of tax on conversion
    • Example: a retiring Boeing engineer with nearly all her investment assets in the VIP plan
    • Any significant conversion will probably have to have taxes paid out of the qualified plan
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • High Net Worth Clients
    • Key question : how long until we need to access the money ?
    • Example: extensive non-qualified holdings mean the client would not need to draw from qualified accounts until well after their required beginning date, if at all
    • Lack of RMDs for Roth accounts would allow for extended tax-free compounding
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Late Life Widow
    • Key question : estate tax versus income tax
    • Converting to Roth removes the resulting income tax obligation from her taxable estate
    • May need to compare beneficiary tax rates in addition to hers
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • If Only It Were That Easy… Planning Under Uncertainty www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Source 1 of Uncertainty: Taxation
    • The Roth conversion question is largely driven by tax rates, so uncertainty in this area is perhaps the dominating factor to consider
    • Applicable taxes to consider include:
      • Federal income taxes
      • State income taxes
      • Estate & transfer taxes
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • The Most Commonly-Anticipated Uncertainty: Increasing Brackets
    • When considering the broad, long-term financial situation of the federal government and the likely need for tax increases, most people think about bumping up the standard rates
    • Even if you believe that tax increases are going to be limited to upper-income taxpayers, that probably means a good portion of most advisors’ client bases will be impacted
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • There’s More Than One Way to Skin a …
    • Tax professionals understand that there are many more ways to enhance revenue than merely increasing rates
      • And these alternatives are typically more politically palatable
    • The recent addition of income-related premiums to Medicare Part B is one example of this
      • For instance, if MFJ 2010 income is >$214,000, the Medicare Part B premium more than doubles (above $428,000, it more than triples)
    • The 3.8% Medicare “surtax” on investment income (or high MAGI) is another example
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Those Roths seemed like a good idea at the time….
    • The government’s expanded eligibility for Roth conversions increases current tax revenues at the expense of future revenues
      • Essentially, Uncle Sam is giving up future revenues in order to collect them now
    • Now, imagine it’s 2028 and the newly-elected Congress (composed of Generation Y slackers) is looking around at these baby boomer Roth multi-millionaires who are paying almost no taxes while sucking up significant Social Security and Medicare benefits.
      • Can you imagine Congress passing a “needs-based amendment” and applying a surtax to Roth distributions, at least for high-income taxpayers?
      • Or applying a special tax to inherited Roth accounts?
      • Or……
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Or maybe it wouldn’t have to do with Roth IRAs at all….
    • “ How could I tax thee? Let me count the ways…”
    • A well-known “feature” of the complex US tax system is that “the leg bone’s connected to the thigh bone” ( or, when a butterfly flaps its wings in Subchapter J, we catch a cold in Section 2036….)
    • Nearly anything that would shift a client’s marginal rate – even over relatively brief windows of their future life – could change the attractiveness of a Roth conversion generally or its timing specifically
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Let’s pick ourselves up, dust ourselves, start all over again?
    • Imagine that we decide replace the federal income tax system with a value-added tax, national sales tax, or some other totally new scheme (sorry, we meant to say schema ) for taxation:
    • Do you have confidence that the change would be made including some sort of “equalization” for clients who had prepaid the income tax obligation on their IRAs?
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • How might state income taxes play into this?
    • Let’s imagine Tom, a retired firefighter from Bellingham, decides his life has too much uncertainty to do a conversion.
      • In 2012, he relocates to Sacramento to be near his grandchildren. Now his IRA distributions are subject to California state tax as well as federal income tax (had he done the conversion while a Washington resident, the distributions would not have been subject to state tax).
      • On the other hand, suppose Tom loves the northwest and wouldn’t relocate – even for his grandkids – but passes away in Bellingham in 2015. His son in Sacramento inherits the traditional IRA, and state taxes are assessed on top of federal tax.
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Estate Taxes
    • Five years ago, many of us probably thought there was a decent chance that estate taxes would be eliminated by 2011.
    • One year ago, the conventional wisdom was overwhelmingly that we would go to a $3.5 million or higher federal exemption.
    • Now we’re beginning to hear talk about the possibility of remaining at a $1 million exemption!
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Source 2 of Uncertainty: Economics
    • Jason had a long career at Chevron and was fully vested in a large portfolio of stock options.
    • The discovery (just before Jason’s retirement) of a commercially-viable application of cold fusion for powering passenger cars led to a collapse in Chevron’s stock price.
      • The decimated value of his stock options means that Jason will need significant distributions from his IRA beginning very soon after his retirement.
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • More Economic Uncertainty
    • Tammy converted her traditional IRA to a Roth in June.
      • Devoting half of the portfolio to futures trading seemed like a way to catch up from the 2008 decline in her portfolio.
      • Unfortunately, Tammy’s inexperience in futures trading, the high costs, and the volatile markets resulted only in further reductions in value.
      • She now owes more in tax on the conversion (based on the June value) than she has left in her portfolio!
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • More Economic Uncertainty
    • Jerry was anxious to complete a Roth conversion as soon as he was eligible – in January of 2010 – and for the most part, he’s pleased.
    • However, his small cap stock investments are down about one-third from their level at the time of the conversion. He’s disappointed at the thought of paying tax on value that’s no longer there.
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Source 3 of Uncertainty: Client Situation & Preferences
    • Example: Marital status changes
      • John & Mary, retirees, may have similar income during their joint life or for one of them as a survivor
      • When Mary passes away, John may bump up to a higher tax bracket due to the switch in tax filing status from married to single
        • Could argue for doing more with conversions to take advantage of the expanded brackets while they are married
        • Could also make conversion more attractive in general due to the higher tax rates in the future
      • Alternatively, if a significant source of taxable income will end at John’s death, could mean that Mary as the survivor would be in a lower future rate, reducing the advantage of a conversion
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • More Uncertainty in the Client Situation
    • Cash flow changes
      • Example: Bill finds he really enjoys sailing now that he’s retired.
        • Requires larger portfolio distributions to fund larger cash flow needs, reducing the Roth’s ability to benefit from delayed distributions
      • Example: After retiring last year, Joan had an unexpected doubling of her portfolio due to receiving an unanticipated inheritance from her aunt.
        • This increases taxable income, making the Roth conversion more attractive
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Further Uncertainty in the Client Situation
    • Todd was deeply estranged from his daughter Sally following a divorce from Sally’s mother when Sally was a teenager; his estate plan called for his estate to benefit the UW.
      • Not much reason for estates going exclusively to charity to consider a Roth conversion
    • Recently, Sally gave birth to Todd’s only grandchild (Allison), resulting in reconciliation between Todd and Sally and a new desire for his IRA to benefit both Sally and Allison.
      • Now a Roth conversion could be very beneficial.
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Further Uncertainty in the Client Situation
    • Jim & Jennifer’s son, Jered, was the sole beneficiary of their estate.
      • Jim & Jennifer were highly motivated to provide assets to Jered in the most beneficial manner possible.
    • Jered passed away after being hit by a drunk driver last year. Jim & Jennifer were launched into a fresh search for meaning in life and found their faith becoming much more important to them.
      • They now wish their estate to benefit their church.
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Dealing with Uncertainty
    • In our analysis
    • In our approach
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Uncertainty and the Analysis
    • Including multi-year analyses
    • Incorporating Monte Carlo simulation
    • Investigating multiple scenarios
      • What if best approach in most likely scenario would be bad result in a reasonably possible scenario?
        • May want to choose approach that is not ideal in most likely scenario, but also not awful in a reasonably possible future
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Uncertainty & Our Approach
    • Life isn’t “all or nothing”
      • Partial immediate conversions
        • Hedge our bets, create “tax diversification”
        • Implicitly acknowledges that we don’t know the future
      • Periodic, systematic conversions
        • Take advantage of routinely “filling up” lower tax brackets
        • Recognizes that we will know more as time goes along
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Uncertainty & Our Approach
    • Can I get a mulligan?
      • Recharacterization gives you a “do-over”
        • Converting in “slices” enhances this
      • Even mulligans have rules
        • Time limits need to be strictly observed
        • Your workplan needs to include triggers for reviewing recharacterization opportunities
      • Re-conversion gives you a do-over on your do-over!
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Conversions in the Real World Practical Considerations www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • 9 Critical Issues / Considerations
    • Recharacterization – the basics
    • Recharacterization on steroids: segregation by asset class
    • Pay now or pay (a bit) later
    • After-tax money
    • Who can convert / what can we convert?
    • Planning linkages (Medicare premium, Social Security taxation, financial aid loss, etc.) (example)
    • Tax planning opportunities (matching up big deductions with big income, etc.) (example)
    • Portfolio management: allocation/location Issues
    • Estate & probate issues
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Recharacterizations
    • Allows for a “do-over” of a Roth conversion
      • “ Heads you win…Tails you get to play again”
    • Taxpayers may “recharacterize” a Roth IRA conversion in the current year or by the due date of the current year’s tax return (including extensions)
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Recharacterizations Timeline www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • “Must we extend, or can we amend?”
    • §301.9100-2(b): Provides an automatic six-month extension (without asking permission from the IRS) for any election that can be made on an extended return
    • One requirement: must have filed return on time (by April 15 th ) or timely filed an extension and filed the return within the extension period)
    • To avoid the hassle of filing an amended return in the event recharacterization is beneficial, may be simplest to just extend and plan to file on October 15, 2011
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Why Might We Recharacterize? www.SoundViewAdvisors.com Advanced Topics in Roth Conversions We may want to revisit the current vs. future tax rate evaluation… Market Value of Account Stable Increased Decreased Value @ Conversion Date $100,000 $100,000 $100,000 Tax @ 25% $25,000 $25,000 $25,000 Value @ Potential Recharacterization Date $100,000 $125,000 $75,000 Effective Tax Rate on Conversion 25% 20% 33%
  • One More Reason to Pay Tax with Outside Funds…
    • Potential recharacterization is another reason to pay conversion taxes from non-qualified funds
      • Example: With effective tax rate of 35%, distribute $1mm from traditional IRA, convert $650,000 to Roth and pay tax with $350,000
        • Can only recharacterize the $650,000
      • If tax paid with non-IRA funds, entire $1mm could be recharacterized
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Mechanics of Recharacterization
    • Identify the date of the original conversion
    • Specify the original dollar value of the portion of the conversion that is to be recharacterized
    • Instruct the Roth custodian to do a trustee-to-trustee transfer to a traditional IRA custodian
      • Must reflect any net income (or loss) allocable to the conversion
      • Cannot be done as a rollover (must be trustee-to-trustee)
      • Can be done with cash or an in-kind transfer of specific assets, but the value & tax impact of the recharacterization is independent of the specific assets transferred
      • The transfer can go to any traditional IRA; does not have to return to the account that was the source of the conversion
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Recharacterization may lead to…
    • Reconversion
      • A “do-over” of the “do-over”
      • Taxpayers have the option to “reconvert” their recharacterization at the later of the following two dates:
        • (1) The tax year following the original conversion OR
        • (2) 30 days after the recharacterization
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Reconversion Dates
    • Example: Jane does a Roth conversion on 1/1/2010
      • She recharacterizes on 11/15/2010
        • Earliest reconversion date = 1/1/2011
        • Pertinent rule: following tax year
      • She recharacterizes on 12/15/2010
        • Earliest reconversion date = 1/15/2011
        • Pertinent rule: minimum 30 days later
      • She recharacterizes on 4/15/2011
        • Earliest reconversion date = 5/16/2011
        • Pertinent rule: minimum 30 days later
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Roth Segregation Strategy
    • Definition – create multiple Roth IRAs to fully utilize the ability of recharacterizing if the converted asset(s) go down in value.
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Roth Segregation Strategy
    • Two primary uses:
      • Administrative
        • Segregate a current year’s conversion from an existing (e.g., contributory) Roth IRA
        • Eliminates need to compute income or loss on converted funds if conversion is recharacterized, since income/loss is reflected in account balance
      • Strategic
        • Proactive : “Over-convert” by segregating IRA holdings by asset class, sector, etc. and performing multiple conversions, then recharacterize to shape finalized conversion for maximum benefit
        • Reactive : Respond to asset value declines by keeping your winners and recharacterizing the losers
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Roth Segregation Strategy
    • Five Step Process:
      • Step 1: Create separate IRAs (asset class, sector, etc.) and/or setup separate Roth’s
      • Step 2: Convert IRA(s) to the separate Roth IRA(s)
      • Step 3: Pay income tax on Roth IRA conversion by April 15 th of the following year
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Roth Segregation Strategy
    • Five Step Process, cont.
      • Step 4: Recharacterize Roth IRA conversion if account value has decreased
      • Step 5: File original or amended income tax return reflecting refund for recharacterization
    • **Steps 4 & 5 must be done by October 15 th of the year following the conversion year
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Roth Segregation Strategy Is it worth the hassle?
    • In 2010 Sally converted holdings worth $50,000 into a Roth IRA with an existing balance of $150,000
      • Roth balance after conversion = $200,000
    • On 4/15/2011 the converted holdings had decreased in value to $25,000 and other holdings were still valued at $150,000
      • Roth balance on 4/15/2011 = $175,000
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Roth Segregation Strategy Is it worth the hassle?
    • Sally is disappointed that the converted holdings are down 50% and wants to “un-do” the conversion and eliminate the tax being paid on the value which has vanished
    • Since there is only one Roth account the $25,000 loss is pro-rated across each holding based on its share of the total account value at the time of conversion
      • Converted holdings = $50,000/$200,000 = 25%
      • Share of loss = $25,000 loss *25% = $6,250
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Roth Segregation Strategy Is it worth the hassle?
    • Without segregation $43,750 ($50,000 value at conversion less $6,250 pro-rata share of decline in account value) will need to be recharacterized in order to eliminate tax on the original $50,000 conversion
    • With segregation the $50,000 of holdings would have been converted to a new Roth account and only that account (now worth $25,000) would need to be recharacterized in order to eliminate the tax hit.
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Let’s recap the advantage:
    • To fully recharacterize and “undo” the conversion requires pulling money out of the tax-free Roth and returning it to the taxable IRA. How much has to be pulled out?
      • Without segregation: $43,750
      • With segregation: $25,000
      • Result: with segregation, an additional $18,750 can remain in the tax-free environment
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • 2010 Conversions Pay Now or Pay Later?
    • For 2010 only, taxpayers have the option to report conversion income in 2010 or spread it evenly over the 2011 and 2012 tax years
      • The two year spread will automatically apply unless an election is made to pay the tax in 2010
      • We presume the tax treatment of a 2010 conversion will be indicated on Form 8606
        • Any other ideas?
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • 2010 Conversions Why pay sooner?
    • The special 2010 rule defers the income, not the tax
    • Means the actual conversion tax amount is not known with certainty, as it will be determined under the rules in effect in future tax years
    • May be less favorable for those near the upper tax brackets to spread the income over 2011/2012
      • Current tax rates are scheduled to sunset in 2010.
      • It is expected that the top two brackets (33% and 35%) will be allowed to increase to their pre-2001 levels (35% and 39.6%)
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • 2010 Conversions: When do we pay?
    • If you elect to have the conversion income taxed in 2010, the tax is due, at the latest, on April 15, 2011
      • Technically the tax would be due earlier unless you qualify for a safe harbor from the penalty for underpayment of estimated tax
    • You may want to pay by April 15 th to preserve the greatest flexibility
      • The penalty for late payment of tax would apply if you:
        • Converted in 2010
        • Did not recharacterize
        • Elected not to push the income forward to 2011-12
        • Failed to pay the tax by April 15, 2011
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • 2010 Conversions Pay Now or Pay Later: Can We Do Both?
    • Only one income reporting method can be used per taxpayer regardless of the number of Roth conversions
    • Married couples
      • Each spouse can choose their own reporting method
      • There is potential to accelerate three years of Roth conversions into 2010 while paying the taxes due over the same three year period.
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • 2010 Conversions Pay Now or Pay Later
    • Married couples example:
      • A married couple is planning to convert $40,000 a year over each of the next three years (2010-2012)
        • Spouse 1 – Converts $40,000 and elects to report the conversion in 2010
        • Spouse 2 – Converts $80,000 and spreads it evenly between 2011 and 2012
        • Outcome
          • $120,000 converted in 2010 and tax hit spread over the next three years ($40,000/year)
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Dealing with After-Tax Money: The Rules
    • Cream in the coffee rule
      • If any IRA has non-deductible contributions (basis) and deductible contributions and/or earnings then every distribution is partially taxable and partially non-taxable
        • Cannot cherry pick the non-taxable portion when reporting distribution for tax purposes
      • Multiply distribution amount by a fraction
        • Numerator – Total after tax money in all IRA’s
        • Denominator – Total value of all IRA’s
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • “Cream in the Coffee”: An Example
    • Client has two IRAs:
      • IRA #1 Balance = $100,000
      • IRA #2 Balance = $150,000
        • IRA #1 Non-deductible contributions = $75,000
        • IRA #2 Non-deductible contributions = $0
        • Non Taxable % = $75,000/$250,000 = 30%
    • Distribution = $50,000
          • Non-Taxable Portion = $50,000 x 30% = $15,000
          • Taxable Remainder = $50,000 - $15,000 = $35,000
          • Doesn’t matter which IRA the distribution comes from
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • But I don’t like cream in my coffee… Is there anything I can do?
    • Rolling to a Qualified Plan
      • Plan must accept rollovers for this to work
      • Non-deductible contributions (basis) cannot be rolled over [see §408(d)(3)(H)]
      • Strategy
        • Roll pre-tax portion of IRA to qualified plan
        • Convert the remainder (which is solely the after-tax portion) to a Roth
        • No taxes due on conversion!
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • So Much for Cream in the Coffee! We Have a “Centrifuge” www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Isolation is Good! An Example of Isolating Basis
    • Example
      • IRA = $150,000
        • After tax portion (basis) = $60,000
      • Roll $90,000 to qualified plan
      • The basis cannot be rolled into the qualified plan, so the $60,000 remaining in the IRA is all basis
      • Now convert the $60,000 remainder to Roth IRA – no income to recognize on the conversion
    • Consider Solo 401(k) for self employed
      • Example: early retiree doing some consulting…
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Who /what can convert to a Roth IRA?
    • IRAs – Traditional, SEP, SIMPLE
      • Beware of 2 year rule for SIMPLE IRAs (25% penalty)
    • Qualified Plans
      • 2009 was the first year this was allowed
      • Two methods
        • Distribution – 60 day rollover period, 20% tax withholding
        • Direct rollover – “trustee to trustee” transfer
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • What About Inherited Plans?
    • Spouse:
      • Can covert an IRA or qualified plan
    • Non-spouse
      • Qualified Plan – Conversion is allowed
      • IRA – Conversion is not allowed
        • For estates with qualified retirement plan assets, this creates an estate administration issue
          • Nonspouses can only convert to a Roth on the way out of the qualified plan, not after rolling the QRP to an IRA
          • Before an IRA rollover is initiated, we need to confirm that we don’t want to move the assets to a Roth environment
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Who /what else can convert to a Roth?
    • Special Cases
      • Current year contributions
        • Nothing prohibits an immediate conversion
        • Wait at least a day so there is clear documentation
      • Series of Substantially Equal Periodic Payments (SOSEPP)
        • Under the current regulation a full conversion would not constitute a modification
        • Lack of clarity around partial conversions
          • Consider proportionate distributions from each account going forward
          • You have until 10/15/2011 to recharacterize if needed
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Oh, that’s connected to this…: Medicare, Part 1
    • Medicare Premiums
      • Part B premiums based on income (most recent tax return filed)
      • A married couple would pay over $6,000 extra if moved into the highest premium bracket
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Another linkage…: Medicare, Part 2
    • Medicare Surtax
      • 3.8% on unearned income once MAGI is above $200,000 for singles and $250,000 for couples
      • Roth conversions are not considered unearned income, but will increase MAGI
      • Does not take effect until 2013
        • Major incentive to accelerate income recognition for those with high taxable income
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • How about connections with that other social program?
    • Background: Taxability of Social Security Benefits
      • Individuals with combined income*:
        • between $25,000 and $34,000 = up to 50 percent of benefits taxable
        • more than $34,000 = up to 85 percent of benefits taxable
      • Couples with a combined income*:
        • between $32,000 and $44,000 = up to 50 percent of benefits taxable
        • more than $44,000, up to 85 percent of benefits taxable
      • *Combined Income:
      • Adjusted gross income
      • + Nontaxable interest
      • + ½ of your Social Security benefits
      • = Your &quot;combined income”
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • What impact might a Roth conversion have on this?
    • Married Couple Example
      • SS Benefits - $26,000
        • Taxable - $2,700
      • Other Income - $33,000
      • No itemized Deductions
      • No credits
    • On the next slide - let’s look at how a Roth conversion will be taxed in this situation
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Are these effective tax rates what you expected? www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • An equal-opportunity complication for the younger generation, too
    • Financial Aid
      • Roth conversions will require parents to enter a higher AGI on FAFSA form
      • At certain levels of AGI this can cause a substantial reduction in financial aid
      • The decision of whether to include Roth conversion income is up to each school
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Tax Planning Traps
    • Rolling to an IRA mid-year
      • Qualified Plan
        • Assets in qualified plans are not considered for the pro-rata rule with non-deductible contributions
        • Rolling a qualified plan over in the same year as a Roth conversion will make the plan assets subject to the pro-rata rule
      • RMDs
        • For those over 70.5, the current year RMD must come out prior to conversion
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Tax Planning Opportunities
    • Net Operation Losses (NOL)
      • Offset current year NOL
      • Use NOL carryovers from prior years
    • Charitable contributions
      • Coordinate with current year contributions
        • Consider funding a Donor Advised Fund or using a split interest trust
      • Use prior year contribution carryovers
    • Convert before beginning Social Security to reduce impact of RMDs on SS taxation
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Portfolio Management Issues: Asset Location Factors
    • Differing rates applicable to various elements of investment return
      • Capital gain versus ordinary income rates
    • Availability of deduction for capital losses
    • Availability of step-up in basis
    • Relative return differentials between various asset classes
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Portfolio Management Issues: General Rules
    • Capital gain assets in taxable account
    • Ordinary income assets in qualified accounts
      • Higher-growth assets in the Roth IRA
      • Lower-growth potential assets in the traditional IRA
    • Manage the various accounts as a single, unified portfolio
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Asset Allocation/Location www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Estate Planning Issues
    • Traditional IRAs are an inefficient way to pass wealth to heirs
      • Incur both estate tax and income tax
      • IRD rules only apply to federal estate tax (no deduction for state estate taxes paid)
    • Traditional IRAs are an inefficient way to fund a bypass trust
      • Roth IRA is tax free and results in the “full” use of the exemption, packing more after-tax wealth into the credit shelter
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Estate Planning & Administration: Items to Consider
    • Non-spouse beneficiaries may only convert an inherited retirement plan to a Roth “on the way out” of the qualified plan
      • Before rolling the QRP into an IRA, review the advisability of a Roth conversion
    • Highly desirable to arrange for adequate estate liquidity so that the Roth can continue and be distributed over the life expectancy of the beneficiaries
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Additional Considerations
    • Tax apportionment clauses should allocate estate taxes away from Roth IRA accounts and allow them to continue to grow
    • The ability to recharacterize extends beyond an individual’s death, so the recharacterization power should be made available to
      • The attorney-in-fact under a durable power
      • The personal representative under a will
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Do You Have Questions? (Alternatively, Any Answers?) www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Wrapping Up www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Recap: 4 Potential Types of Roth IRA Conversions
    • Strategic Conversions – related to long-term wealth transfer objectives
    • Tactical Conversions – connected with investor-specific, shorter-term tax attributes
    • Opportunistic Conversions – tied to economic and investment situations
    • Hedging Conversions – made with potential tax rate changes in mind
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Slam Dunks are Rare
    • Rules of thumb can be rules of dumb!
    • The conversion decision has more moving parts than any other planning choice we can think of
    • Someone will almost always have to “run the numbers” for the client to have the best information needed
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Collegiality
    • The conversion question is a complex, yet critical planning issue
      • Impossible to ignore! (to ignore is to decide)
    • Clients deserve well-coordinated recommendations from their key advisors: CPA, attorney, financial planner
    • We look forward to working closely with you on assumptions, decision frameworks, analyses, and recommendations for our common clients
    www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Conclusion You’ve learned about us: We want to learn about you! www.SoundViewAdvisors.com Advanced Topics in Roth Conversions
  • Thanks for joining us! www.SoundViewAdvisors.com Advanced Topics in Roth Conversions