Let’s spend a moment reviewing the reasons why Roth IRAs make sense for so many people today. For starters, a Roth IRA always involves after-tax dollars, whether it is a contributory Roth, where money is invested regularly, or if it is created by converting an existing workplace retirement plan or traditional IRA to a Roth IRA. While this should be seen as primarily a retirement tool, there may be advantages to using Roth IRA funds for a first time home purchase. This can make Roth IRAs more attractive to younger individuals who are having a hard time focusing on saving for retirement (those with earned income but who don’t necessarily need a deductible IRA, for example). Like other types of IRAs, there are exceptions to the 10% penalty for premature distributions from Roth IRAs. However, the Roth IRA has a bit more flexibility in this regard, namely that there is an ability to withdraw dollars that were contributed without penalty. The Roth is a great legacy planning tool, allowing you to stretch the tax-free features beyond your own lifetime, so beneficiaries can also capitalize on the tax advantages for many years. If distributions are managed properly, they may be income tax free. No tax or penalty should apply to “qualified distributions.” See IRS Publication 590, but basically, a qualified distribution is one that is made AFTER the 5-year period beginning with the first taxable year for which the contribution was made to a Roth IRA, AND, the payment or distribution is: (1) made on or after you reach age 59 ½, or (2) made because of disability, or (3) made to a beneficiary after the Roth IRA owner’s death, or (4) one that meets the requirements as a First Home purchase (up to a lifetime limit of $10,000 of earnings allowed to be withdrawn, after principal, tax-free). Income requirements to qualify for a contributory Roth are generally fairly high, so a large number of investors can participate in this way. And a big reason for our talk today is a significant change to conversion rules, which will make Roth conversions a real possibility for many individuals in 2010. In fact, this change in the law will essentially open the door to everybody to at least consider a Roth IRA.
While the new rules opening up Roth IRA conversions to everybody are our primary focus, it is important to remember that many of you may well qualify to make Roth IRA contributions this year and for years to come. Starting in 2010 there are no income limits on eligibility for Roth conversions but remember there are still income limits on eligibility for Roth IRA contributions . Here’s a quick recap of the 2009 eligibility rules surrounding Roth contributions. These are the 2009 income limits (based on Modified Adjusted Gross Income). [Read information on slide] The maximum amount that can be contributed in 2009 is $5,000 or 100 percent of earned income, whichever is less. An additional $1,000 is allowed for those age 50 or older.
Now let’s move to our primary topic – Roth IRA conversions. Here are factors that may determine if a Roth IRA conversion is advantageous. Let’s walk through them Required Minimum Distributions do not apply to dollars that are part of a Roth IRA. So for those who don’t need the money at age 70½, the dollars can keep working on a tax advantaged basis in the Roth, and they will not be forced to take distributions as is the case with traditional IRAs or employer-sponsored retirement plans. NOTE: Dollars accumulated in a Roth 401(k) plan are subject to required minimum distributions generally beginning at age 70½. Converting assets to a Roth IRA and paying income taxes at the time of the conversion, could provide the benefit of lowering the value of your estate. Individuals who are dealing with a Unified Credit bypass will be better positioned to use a Roth IRA to increase the net value of the trust by funding it with after-tax dollars. If the 5-year holding period has been met when a spouse or non-spouse inherits a tax-free Roth IRA, the distributions will not push the beneficiary into a higher income tax bracket. So the tax benefits can carry beyond the life of the Roth IRA account holder. If the individual expects his or her tax bracket will increase, the tax-free income will be more valuable at that time. Those who have tax-paid resources to pay the conversion tax and have time to let the asset grow will be best positioned to benefit from a Roth conversion. If there is a significant time frame to allow the converted assets to grow Timing may be advantageous. Recent market declines will help reduce the current tax impact of a conversion.
This slide demonstrates what may just be the “silver lining” in this financial downturn. This scenario shows the result of a conversion during a temporary market decline followed by a recovery. [Read scenario on the slide] Being able to do a conversion during a market decline can also save some money on the taxes due upon conversion. Of course no one really knows how to hit the “bottom” of the market. The value of an IRA that is converted to a Roth may continue to decline and it may be worth LESS than the market value that was reported…and taxed…when the conversion was done. It should be noted that if someone converts to a Roth and the market continues to decline, you might be able to reverse your decision to convert to a Roth. In other words, the taxpayer still has the option to “undo” it by declaring a “recharacterization”, which can generally be done until October 15 th of the year following the year of conversion. This recharacterization process can be complex and specific rules must be followed. This is why it’s important to seek guidance from both a financial advisor and a professional tax advisor.
Under rules in place through 2009, the ability to convert to a Roth IRA is limited to only those who have Modified Adjusted Gross Income of $100,000 or less. This income level applies whether we’re talking about a single person or a married couple filing a joint return. Taxpayers using “married, filing separately” cannot currently do a conversion, but that rule changes in 2010. In 2008, rules changed, allowing individuals to convert money directly from an employer-sponsored retirement plan to a Roth IRA, saving the step of first rolling the money into a traditional IRA. Of course, just as with a traditional IRA to Roth IRA rollover, this is a taxable event, with all pre-tax contributions and earnings subject to tax when the conversion occurs. A direct rollover can occur between a Roth 401(k) and a Roth IRA, and in that situation, there are no current tax liabilities. However, the five tax-year holding period required before tax-free withdrawals can occur will be re-started once the conversion to a Roth IRA occurs.
Changes are taking place in 2010 that will have a significant impact on the Roth IRA conversion opportunity. Most important, as I indicated earlier, is that anybody will be eligible to convert to a Roth, regardless of their current income level. So essentially, come 2010, every individual could consider a Roth IRA conversion. What’s more, there is a specific opportunity that applies only to conversions that occur in 2010. The income generated by the conversion does not have to be claimed for that tax year, but can be applied equally over two years, 2011 and 2012. While the 2010 conversion may be spread over 2011 and 2012, the custodian or issuer of the plan being converted will report the distribution on Form 1099-R for 2010. The assumption will be that the income that must be claimed when the conversion occurs will be spread over the two subsequent years. To choose not to would be to claim the income for 2010.
For example, let’s assume a $70,000 conversion occurs in 2010. If it was all claimed on the 2010 tax return, and assuming that half of the conversion is taxed at 25% and half is taxed at the 28% bracket, this would result in about $18,550 in additional taxes due for the tax year 2010 (payment due on or before April 15, 2011). Under the one-time opportunity to spread the income from the conversion ratably over two years, this would mean $35,000 is to be reported in 2011 and another $35,000 in 2012. By spreading the income out over two years, you might be able to stay in a lower tax bracket when determining the tax liability associated with the converted amount. If the tax brackets stayed the same and assuming the entire $35,000 each year is taxed at 25%, the additional tax each year would be about $8,750, or a total of $17,500 for both years. In this example, that would amount to a tax savings of $1,050. This may be a good opportunity as the combined taxes for both years may be less than the tax if the income is all reported in one year.
Just to clarify what the rules mean for somebody looking to convert their Roth IRA in 2010, 50% of the income will be reportable on the 2011 tax return, meaning that the first portion of the tax due on the conversion will not be due until April 17, 2012*. The remaining 50% of the income will be reported on the 2012 tax return, and that portion of the tax due will not need to be paid in until April 15, 2013. Clearly, this is a very advantageous tax-deferral, and possibly tax-saving opportunity for individuals who complete a Roth IRA conversion in 2010. Be aware that the need to make estimated tax payments to avoid an underpayment penalty may require earlier payment of the taxes attributable to the conversions. A tax advisor can help determine whether estimated tax payments are necessary to avoid penalty. * The tax filing deadline (without extension) in 2012 is after the weekend and Emancipation Day, which means it will be April 17, 2012
Most people who complete a Roth conversion in 2010 will be required to pay taxes on at least some of the converted amount. The timing of a 2010 conversion is quite favorable for many. We already talked about the special tax treatment with a 2010 conversion – and the ability to spread out the tax impact over 2011 and 2012. This is important because it provides you with an option to manage the conversion amount in an effort to stay in a lower tax bracket. Since there is enough flexibility to split the tax liability into the 2011 and 2012 tax years, it increases the possibility that individuals can avoid moving into a higher tax bracket when they complete the conversion. From a timing standpoint, we also talked about the fact that many IRAs and other forms of retirement savings have lost value from the peak they may have reached in previous years. This can, in effect, limit the tax liability. Finally, many anticipate that tax rates in the future could be headed higher, given that government spending has risen dramatically and future spending commitments, like growing Social Security and Medicare payments, will create an increased demand for revenue. Proposals under consideration now involve raising tax rates on those in the highest income tax brackets, namely families with taxable incomes of more than $250,000 per year. For those who could be affected by such a change in the future, they will likely save money by converting to a Roth IRA sooner rather than later.
The first strategy for us to review is simply to contribute regularly to a Roth IRA – if they qualify under the income limits. Even if in cases where clients who are parents do not qualify under the income rules, we encourage their children who have earned income to consider the benefits. As we mentioned earlier, those who don’t qualify to make contributions or to convert to a Roth IRA in 2009 for income reasons can make traditional non-deductible IRA contributions now and then convert those dollars in 2010. Be aware that there are special rules – called pro-rata rules – that can affect the tax consequences when you convert assets to a Roth IRA. Children who have earned income and are considering an IRA could choose a Roth IRA rather than making tax-deductible contributions. Generally, children are in a low tax bracket today, and get fewer tax-saving benefits now than if they choose a Roth IRA and have the benefit of tax-free withdrawals later in life.
Show clients the great opportunity children have to use the power of time and compound earnings to accumulate a nice little nest egg over time. While in current dollar terms, we’re not talking a big sum of money, there are other great opportunities created. One is that getting the kids started now teaches them the value of saving and investing over time. Those who contribute today not only are saving for retirement. The money could be available later to help fund a first home purchase. They also can take advantage of the Roth’s tax treatment, where contributions are deemed to be the first dollars withdrawn, and only when that is exhausted are earnings withdrawn. So if need be, money is accessible, though they should always be encouraged to take advantage of long-term tax deferral and avoid any early withdrawals.
As an advisor, I like to conduct a Roth IRA conversion planning discussion with eligible clients. Come 2010, that could mean every one of my clients. Let me walk through some of the issues we consider in a planning discussion. We talked about the aggregation rules and how they do not cross over Social Security numbers. It could be that a spouse who already has some IRA or qualified plan assets could convert his or her dollars sooner than 2010, depending on expectations for future tax rates. Some might be reluctant to convert their dollars knowing it creates a current tax liability. But we emphasize the importance of tax diversification in retirement. It could be a real advantage to have some assets available that are not subject to tax when taking distributions later in life. Part of the planning discussion is to determine the best ways to pay the tax that is due. Of course, this is something to discuss with your financial advisor and your tax advisor. One important option is to consider paying the tax from tax-paid dollars, rather than using tax-deferred money from a qualified plan or IRA which would create more taxable income and possibly a premature distribution penalty, depending on the the age of the individual. Using tax-paid dollars, such as money you have tucked away in a savings account, creates the ability to maximize the tax advantages of keeping money at work in the Roth IRA.
We have found that the Roth IRA is a great vehicle to lead into a legacy planning discussion – one that many individuals and families need to take seriously but often delay. The Stretch IRA concept is one reason Roth IRAs are so attractive. The tax-advantaged aspects of a Roth can carry forward for beneficiaries. Only the distributions that are received prior to the end of the five-year holding period would be subject to tax. Beyond that point, all distributions are tax and penalty free.
The final key concept I want to address today is tied to conversion planning for those individuals who have recently entered the retirement phase of their lives. I find that many clients assume that by the time they reach retirement, it is too late to consider converting to a Roth IRA, but this is not the case. For starters, they may have just entered a lower tax bracket. So this could be the right time in their lives to consider converting all or part of their IRA, particularly with the potential of spreading the tax liability out over two years if the conversion is made in 2010. Also from a timing perspective, depending on how the assets are invested, retirement accounts have likely lost value or have been relatively flat in terms of value. So better to make that conversion now than on the heels of a major market rally. Let the rally come after the money is safely tucked away in a “tax-free” Roth. If the market continues to decline, there may be an opportunity to “recharacterize” the converted assets back to a traditional IRA (next slide). If a converted sum is recharacterized, it is possible to “re-convert” back to a Roth IRA at a later date, that re-conversion must take place the later of 30-days after the recharacterization or the beginning of the new calendar year following the original conversion. For those already required to take distributions from a traditional IRA, the distributions are generally taxable, and are not convertible to a Roth IRA. But once the conversion is made, required distribution rules no longer apply. All of these factors can contribute to the case for a Roth conversion for those who have already reached retirement age.
Recharacterization of a Roth conversion can generally be implemented by October 15 th (the tax filing extension deadline) of the year after the year in which the conversion occurred. There are several rules regarding this procedure and competent tax and legal advice is extremely valuable. We encourage our clients to obtain that when we work with them in these situations. Those considering a recharacterization, may want to seek an extension before filing their final tax return. By doing this, it avoids having to file an amended return if the decision to recharacterize is made between the standard April 15 th filing deadline and the October 15 th extended deadline. Also, the rules do not allow multiple “reconversions” after a recharacterization, but it is allowed once. A re-conversion cannot occur before the later of the beginning of the year following the original conversion, or the end of the 30 day period beginning with the date of the recharacterization. This is a very critical point for those seeking to find the low points in the market. Again, this should be done thoughtfully and you as a tax advisor as well as other professionals such as attorneys can play an important role in this process.
Let’s summarize some factors that should be consider to help you determine if Roth IRAs are a good fit. One of the biggest is, of course, the tax benefit. Can individuals project that their tax bracket in retirement will be comparable or even higher than it is today? Those who can are definitely strong candidates for a Roth conversion. Are “outside” dollars, meaning money from a taxable account, available to pay the tax due on the conversion? The conversion is less beneficial if money has to be drawn out of the IRA to pay for it. How much time is left to let the money continue to grow? This is a secondary issue, as even some retired clients can benefit from a conversion, as we just discussed. There is an issue tied to Income in Respect of a Decedent. Double taxation can be avoided by having money in a Roth IRA passed on to a beneficiary, since there is no income tax due on distributions from the Roth. However, the value of the net of the estate income taxes already paid is included for estate tax calculations. Market conditions also may help determine the timing of a Roth conversion. Again, the current environment, with a depressed market, has created more favorable opportunities to convert assets, as earnings have been limited in recent years. That results in a lower current tax liability on the converted amount.
Thank you for attending today’s program. Please pick up one of my business cards before you exit the room today.
<ul><li>Always bought with after-tax dollars </li></ul><ul><li>May be used for a first home purchase (restrictions apply) </li></ul><ul><li>Exceptions to the 10% premature distribution penalty tax </li></ul><ul><li>A great legacy planning tool </li></ul><ul><li>Tax-free withdrawals for qualified distributions* </li></ul><ul><li>Contributory Roth an option for many </li></ul><ul><li>Roth IRA conversions available to fewer now, but to everyone by 2010 </li></ul><ul><li>* See IRS Publication 590 </li></ul>Why a Roth IRA
<ul><li>$5,000 maximum contribution in 2009* </li></ul><ul><li>$1,000 “catch-up” contribution for those age 50+** </li></ul>Contributory Roth IRA Rules (2009) <ul><li>Maximum contribution limits may be adjusted for inflation in future years. </li></ul><ul><li>** Catch-up contribution limits for IRAs and Roth IRAs are not indexed for inflation </li></ul>Contribution allowed Single filer Married, filing jointly (MAGI) Full contribution allowed Under $105,000 Under $166,000 Partial contribution allowed $105,000 ≥ and ≤ $120,000 $166,000 ≥ and ≤ $176,000 No contribution allowed $120,000 and up $176,000 and up
Reasons to Consider a Roth IRA Conversion <ul><li>No distributions required at age 70 ½ for the original owner or, if rolled over to their own IRA, for spouse beneficiary (if treated as an inherited IRA, RMD rules apply ) </li></ul><ul><li>Potential to lower the value of estate that is later subject to estate tax (when compared to a traditional IRA) by paying tax at the time of conversion </li></ul><ul><li>To fund Unified Credit bypass, which has the potential to increase the net value of the trust by funding it with after-tax dollars </li></ul><ul><li>Tax-free Roth IRA distributions won’t push a surviving spouse into higher income tax brackets </li></ul><ul><li>If the current tax bracket is lower today for the individual (or the beneficiary) than it is likely to be later in life </li></ul><ul><li>If there are tax-paid assets to pay the conversion taxes </li></ul><ul><li>If there is a significant time frame to allow the converted assets to grow </li></ul><ul><li>If there is a market decline – converting the lower market value assets and allowing them to grow back tax free (assuming market recovery) </li></ul>
Conversions in a Declining Market <ul><li>Assume a $50,000 IRA has declined in value to $35,000 </li></ul><ul><li>A conversion is done when the IRA is at $35,000 </li></ul><ul><li>Taxes due are on the conversion at market value ($35,000 rather than $50,000). Assuming a 25% tax bracket, the tax savings for converting at $35,000 instead of $50,000 is about $3,750* </li></ul><ul><li>Assuming the IRA recovers and grows back to $50,000, the $15,000 gain is now potentially tax free** </li></ul><ul><li>*Assuming that all assets in the IRA were pre-tax assets at the time of conversion. </li></ul><ul><li>**Assuming withdrawal of earnings meet the requirements to be a ‘qualified distribution’ </li></ul><ul><li>This hypothetical example is provided for illustrative purposes only. </li></ul>
<ul><li>Must have MAGI of $100,000 or less to qualify </li></ul><ul><li>Now can convert directly from employer-sponsored retirement plan to Roth IRA </li></ul><ul><li>Can make direct rollover from Roth 401(k) to Roth IRA with no current taxation </li></ul><ul><li>Married filing separately cannot convert (that rule changes in 2010) </li></ul>Roth IRA Conversions – Pre-2010 Rules
<ul><li>No income limit on Roth conversions </li></ul><ul><li>For 2010 conversions only, the income realized upon conversion can be spread out ratably (reported in two equal installments) over 2011 and 2012 </li></ul><ul><li>Can convert regardless of filing status </li></ul>Roth IRA Conversions – Effective 2010
Example of Roth 2010 Conversion Tax Savings <ul><li>$70,000 converted from traditional to Roth IRA </li></ul><ul><li>$70,000 subject to current taxation </li></ul>x 28% tax bracket x ? tax bracket x ? tax bracket Hypothetical example. For illustrative purposes only.
Extended Deadline to Pay Tax on Roth 2010 Conversion <ul><li>50% of income reportable in 2011, tax due in April of 2012 </li></ul><ul><li>50% of income reportable in 2012, tax due in April of 2013 </li></ul>
Roth IRAs 10% tax bracket 15% tax bracket 25% tax bracket 28% tax bracket 33% tax bracket 35% tax bracket Current taxable income Target Roth IRA conversion amount
<ul><li>Those who qualify can open contributory Roth IRAs (if they have earned income; a “spousal” IRA does not require the spouse to have earned income) </li></ul><ul><li>If ineligible to make a Roth contribution or conversion, can still make traditional IRA contributions, deductible or not, and convert in 2010, but pro-rata rules should be considered </li></ul><ul><li>Encourage contributions for children who have earned income (better to go with after-tax contributions today while they may be in a lower tax bracket for tax-free withdrawals later, rather than tax-deductible contributions now) </li></ul>Roth Strategy #1 Regular Contributions
<ul><li>Consider advantages of tax-free income later in life versus tax-deductible contributions now </li></ul><ul><li>Roth IRA assets can be tapped (up to $10,000) to help in purchase of first home (principal can be tapped first at anytime for any reason – then earnings after the 5-year waiting period may be withdrawn tax-free up to $10,000 for house) </li></ul><ul><li>Principal used first, then earnings withdrawn </li></ul><ul><li>If a child’s IRA is funded from parental gifting (or gifts from others), remember the gift limit annual exclusion is currently $13,000 per year, subject to inflation adjustment in the future. Remember that the child must have earned income sufficient for the amount of the contribution </li></ul>Benefits of Roth IRAs for Children
<ul><li>2010 opportunity can apply to everybody </li></ul><ul><li>Consider the potential for each spouse </li></ul><ul><li>Aggregation rules do not cross over Social Security numbers </li></ul><ul><li>Consider conversion today for spouse with IRA or qualified plan assets still accumulating </li></ul><ul><li>Value of “tax diversification” </li></ul><ul><li>Start planning for how tax liability will be paid when conversion is made </li></ul><ul><li>Consider making after-tax contributions to a 401(k), if allowed, if already making maximum pre-tax and/or Roth 401(k) contributions (after-tax deferrals count against the IRC section 415 limit and not the 402(g) deferral limit) </li></ul>Roth Strategy #2 Conversion Planning
<ul><li>A great “Stretch IRA” – the Roth IRA is the gift that keeps on giving – and with generally NO taxes! </li></ul><ul><li>Only distributions of earnings received prior to five-year holding period (from when Roth IRA was established by the original owner) are subject to taxation. Note that a spouse beneficiary may use the better of their own 5-year holding period or the 5-year holding period of the deceased IRA owner. </li></ul><ul><li>Beyond that, all distributions are tax and penalty free (if a spouse beneficiary rolls the death proceeds into her own Roth IRA, distributions may be subject to the 10% penalty tax) </li></ul>Roth Strategy #3 Legacy Gifts via an Inherited Roth IRA
<ul><li>Still an option for those already retired </li></ul><ul><li>They may have entered a lower tax bracket year </li></ul><ul><li>A period of flat or declining market returns may also be beneficial </li></ul><ul><li>RMDs not convertible, but remaining assets in qualified plan or traditional/deductible IRA can be converted </li></ul>Roth Strategy #4 Conversion Planning in Early Years of Retirement
Recharacterization <ul><li>A taxpayer is allowed to “undo” a conversion and have the net effect as though the conversion never occurred </li></ul><ul><li>The latest date for filing for a recharacterization is generally October 15 th of the year after the year in which the conversion was made. </li></ul><ul><li>There are several rules concerning recharacterizations, such as no “cherry picking” of accounts to be recharacterized; a latest date before reconversion, etc. Therefore, we always involve the clients’ accountant whenever recharacterization is being considered. </li></ul>
<ul><li>Key Considerations </li></ul><ul><li>Tax rate differential – Year of conversion vs. withdrawal years </li></ul><ul><li>Use of “outside funds” (non-qualified tax-paid dollars) to pay the income tax liability on the conversion </li></ul><ul><li>Time horizon </li></ul><ul><li>IRC § 691(c) “effect” (Income in Respect of a Decedent double taxation issue is eliminated since there is no income tax due on distributions…it is counted in the estate for estate tax purposes, however.) </li></ul><ul><li>Market conditions </li></ul>Factors to Consider Before Choosing a Roth IRA Conversion
<ul><li>The Case for Roth IRA Conversions </li></ul>