Roth Conversions for 2009 and After: Lifetime Opportunities to Increase Wealth Now and Beyond the Current Generation
Introduction to Benefits
Roth IRAs are one of the best tax benefits in the tax code. After-tax dollars are contributed to a specifically designated account entitled “Roth IRA” and once a five-year period from January 1 of the first year of contribution and the contributor has reached age 59 ½, all earnings, dividends, gains withdrawn are tax-free. A Roth IRA can be passed on to one succeeding generation without the deceased owner ever having to withdraw monies from the account. The heirs to the account will have to take distributions. Even so, the tax-free feature allows IRA accounts to grow over the years to huge sums.
In summary, the benefits of having a Roth IRA are as follows:
► Tax free income forever
► No required distributions at age 70 ½ (unless it is an inherited IRA)
► After-tax contributions can be withdrawn tax free at any time.
► Roth IRA beneficiaries can take distributions over their life expectancy
► Future tax rate increases will make Roth IRAs more valuable
► Conversions can be undone up until October 15th of the following year
► Conversions for a trust beneficiary avoids the problem of bracket creep
► Taxpayers with low or no taxable income benefit from conversions
► Conversion income in 2010 can be reported as income in 2011 and 2012
Since it is quite possible that tax rates will be increasing significantly in the near future, the next few years offer what could be a once in a lifetime opportunity to protect some of the retirement funds from tax confiscation.
The Key Law Change
Under present law for 2009 or prior, the adjusted gross income in the year of conversion had to be under $100,000. Also, contributions to Roth IRAs were restricted to single taxpayers with modified adjusted gross income of more than $120,000 and married taxpayers filing jointly with modified adjusted of more than $176,000. Starting in 2010, the $100,000 restriction is gone but the modified adjusted gross income restrictions are still in place regarding contributions. As long as the tax is paid, any traditional IRA, SEP IRA, or SIMPLE IRA can be converted to a Roth IRA.
Conversion Rules for 2009
In 2009, the $100,000 adjusted gross income limit applies and any conversion must be reported as income entirely in 2009. Planning a conversion in 2009 may make sense when the taxable income is low, zero, or negative. A conversion may make sense if the taxpayer is terminally ill and expected to pass away with a large taxable estate. The income tax on the conversion will reduce the assets reportable on the estate tax return. Conversion can even make sense for the seven-figure IRA account.
Conversion Rules for 2010
Starting January 1, 2010 anyone with a 401(k), SIMPLE IRA,SEP, or a traditional IRA can convert to a Roth IRA because the $100,000 ceiling is gone forever, relatively speaking (there is really no such thing as “forever” in the tax law because Congress can change tax laws at any time).
An election may be made to report the income over two years, 2011 and 2012. That special election only applies to 2010 conversions. Tax rates in 2011 and 2012 will apply. That’s the risk of electing to defer income instead of reporting the 2010 conversion in 2010. Watch out for increasing tax rates in 2011. Taxpayers and their advisors will want to do computations to weigh the discounted present value of the taxes paid over two years versus the potential for an increase in tax rates applicable to those years.
Tax Rates-What Rate Do You Want to Pay
Roth IRA conversions allow taxpayers and their advisors to work out exactly what tax they want to pay and at what rate. They do that by projecting the tax bracket for the year of conversion, deciding how much to convert, what the marginal rate will be, and whether present value of the number of years of tax-free earnings can justify the upfront tax payment. Taxpayers and their advisors must consider the projected lifetime expectancy of both the primary and contingent beneficiaries. It is not an easy computation, but one that can be attempted on a hand-held HP calculator. In our practice, we have software which is specifically designed to effectively and efficiently determine whether a conversion makes sense.
Example:
Ricard Segenthou has a negative taxable income of $15,000 due to the recession. He decides to convert $30,000 in 2009 because the tax rate will be 10% on the $15,000 that will be taxable, he has the cash to pay it, but he doesn’t want to pay more because of future planned uses for his excess cash.
Low Tax Rates in 2009 and 2010 – A Lifetime Opportunity
Starting January 1, 2011, the following changes, a combination of a reversal of the Bush tax cuts, plus new proposals of the current administration, will apply:
► The 10% tax bracket will be eliminated. The rate will go to 20%.
► The special dividend and capital gain rates will be eliminated for
for joint filers with incomes over $250,000 ($200,000 for singles)
the maximum capital gain rate will increase to 20% for joint filers
with incomes under $250,000 and singles under $200,000, less
the standard deduction and two personal exemptions
(one personal exemption for singles);
the dividend rate will be the ordinary income tax rate, for joint filers
over $250,000 ($200,000 for singles).
the highest dividend rate could be 39.6% for high income taxpayers.
► The 15% tax bracket for joint filers will shrink from 200% to 167%
of the upper limit of the 15% bracket for single filers, creating
a marriage penalty.
► The standard deduction for joint filers will shrink from 200% to 167%
of the standard deduction for single filers, creating a marriage
penalty.
► Income tax rates will increase between 3% and 4.5% for each
bracket on January 1, 2011.
► The 33% rate will increase to 36% with the same income minimums
as those for the special dividend and capital gain rates, $250,000
and $200,000, less the standard deduction and personal exemptions.
► The top marginal rate will increase from 35% to 39.6%; for 2009 the top
rate applies to joint filer taxable income over $372,950.
After 2011, the government debt will be trillions, not billions, higher than it is today. In addition, the Democratic Congress and President are committed to bigger government which takes money to fund the programs. Since there is a limit on the amount of debt a country can issue, the money has to come from the taxpayers. The only question is how much will the middle class have to pay. My guess is the middle class will eventually have to pay more tax. Accordingly, 2009 to 2010 may be the best years to convert due to lower tax rates.
Massachusetts Tax Treatment of Roth IRA Conversions
Massachusetts allows a deduction for after-tax IRA contributions that were effectively taxed as earnings in Massachusetts. In other words, no deduction was allowed on the Mass tax return. Any excess over the contributions will be taxable upon a conversion to a Roth IRA. So you will need to know the amount of your after-tax contributions.
Massachusetts has a flat tax rate of 5.3%. Theorically, the tax is deductible on the federal return, if the taxpayer itemizes and is not subject to the alternative minimum tax. That helps to reduce the effective rate of Massachusetts tax on the conversion.
Massachusetts residents who were nonresidents will not be able to offset the amount of the conversion income with contributions made while a resident of another state.
Otherwise, Massachusetts follows the federal treatment for Roth IRAs. Contributions are nondeductible and distributions are nontaxable.
Younger Taxpayers Have an Advantage
Suppose Thor Heyermenow, age 30, is a college graduate with a graduate degree and has been looking for work for two years. He has a modest traditional IRA. The present value computations are bound to work out for him. He has 35 years before retirement and if he doesn’t draw on it at all, he probably has 50 years (assume increased life expectancy) to let a Roth IRA account compound tax-free because his earnings will be high enough to finance his retirement with other retirement savings vehicles such as 401(k)s. His total tax cost could be low even though the marginal rate might be higher than 15%, assuming he is working pretty soon. It’s almost a no-brainer.
High-Income Taxpayers Have an Advantage
The income caps prevent high-income taxpayers from contributing directly to a Roth IRA, currently $120,000 of modified adjusted gross income (MAGI) for single taxpayers and $176,000 MAGI for married filing joint returns. However, they can first contribute the annual maximum ($5,000 for 2009 plus a $1,000 make-up contribution for taxpayers age 50 or older) to a nondeductible account. There is no income cap for nondeductibles.Then they can convert the nondeductible account to a Roth IRA. If there are no other traditional IRA accounts, the conversion will be at a very low tax cost. The only taxable income will be the earnings for approximately one tax year.
Potential Taxable Estates Have A Tax-Saving Opportunity
A Roth IRA conversion for an account owner who is wealthy, aged and ill with present or possible future health issues, will be able to reduce their taxable federal and state estates by using non IRA assets to pay for the conversion tax liability. Combined federal and state estate marginal tax rates can exceed 50%. Reducing the estate by using a Roth IRA conversion helps to reduce the overall tax cost.
Taxpayers Subject to AMT May Have an Continuing Opportunity
Taxpayers subject to the AMT are generally high-income taxpayers who live in high-tax states,such as New York, California, and Massachusetts. Under the current regular rate structure, the maximum rate of alternative minimum tax is 28%. That’s lower than the 2008 maximum regular tax rate of 35%. It’s obviously higher than the 10% and 15% rates. All this means is that strategies and techniques need to be utilized by taxpayers and their advisors to lower the rate. For example, deferring income for the year of the contemplated conversion to a later year and accelerating deductions into the year to conversion are two common ways to lower taxable income and the regular marginal tax rate.
Taxpayers subject to the AMT tax, as high-income earners, may be subjected to high regular marginal tax rates in the future, more likely starting in 2011 when the Bush tax cuts will have expired. If the AMT marginal rate remains at 28%, the higher regular marginal tax rates will have no impact. However, it is by no means certain that Congress will leave the 28% unchanged. Therefore, the less risky course is to not make the deferral election, allowing the conversion income to be taxed in 2011 and 2012.
The Prorata Rule
Taxpayers and their advisors have been using the strategy of contributing to a nondeductible traditional IRA whenever the modified adjusted gross income limits prevent direct contribution to a Roth. However, the tax on conversion is figured by taking into account the total value of all IRA accounts, including taxable traditional IRAs and rollover IRAs.
Example:
Eddy Schoenhammer wants to convert his nondeductible traditional IRA in the amount of $10,000. His pre-tax contributions were $8,000. He has two other IRA accounts which are taxable. Altogether, the total IRA accounts amount to $90,000. The taxable amount of the nondeductible traditional IRA will be $9,111, or 8.889%, determined by adding the two accounts together and dividing the $8,000 by $90,000. The nontaxable amount is $889 and the remaining cost basis will be $7,111. Form 8606 will need to be filed to preserve the cost basis. Failure to file the form can result in a $50 penalty.
The Five-Year Rule
The five-year rule says that if an traditional IRA account owner wants to have both a penalty-free withdrawal of contributions and a penalty-free withdrawal of earnings, the account owner needs to have first contributed to the IRA five years before the withdrawal and be at least age 59 ½. The first contribution is treated as if made on January 1st of the year for which the contribution is made.
For Roth IRA distributions, there are two different rules:
Rule 1) This rule is similar to that for traditional IRAs except for the conversion piece. Since tax has already been paid on the contributions or conversion money, a penalty-free withdrawal of earnings can only be made after the Roth IRA is held for five years and the owner is 59 ½ at the time of the withdrawal. Both requirements must be met.
Rule 2) The second rule is for Roth IRA conversion piece which says that if the owner is under 59 ½ and the account has not been held for five years, there is a 10% penalty on the conversion portion as well as the Roth earnings portion of the withdrawal. But if the owner is over 59 ½ and the 5-year holding period has not been met, the conversion piece can be withdrawn tax free. This is not to be confused with the rule that says withdrawals of contributions from a contributed Roth IRA are tax free regardless of when they are made.
If account owner is over the age of 59 ½ and has held the account for five years, he or she can make penalty free withdrawals of both converted Roth IRA money and Roth earnings.
If the account owner has just reached the age of 59 ½ but has not held the Roth IRA for five years, there will be a penalty on the Roth earnings portion of distributions only. Reaching age 59 ½ does remove the 5-year holding period on the conversion piece but not on the Roth earnings piece, according to IRS Publication 590.
Each Roth IRA conversion starts the five-year “clock” again, for that conversion and only for account owners under age 59 1/2. It doesn’t change the “clock” for prior conversions, however.
When making withdrawals from a Roth IRA, there is an ordering rule. The distribution dollars come first from regular contributions, then from conversion and rollover dollars, on a first-in first-out basis, taking the taxable portion first and then the nontaxable portion, and finally from earnings on contributions while the account was a Roth IRA.
Practically speaking, Roth earnings hardly ever get taxed. It is important to remember that contributions come out first, tax free, regardless of the five-year rule or age. That rule of tax law allows parents to set up Roth IRAs for college and avoid taxation if earnings are not withdrawn.
Examples:
Flo Slockenspleen, age 55 on May 15, makes her first contribution to her Roth IRA on December 15, 1995 for the year 1995. She contributes every year thereafter. She can make a penalty free withdrawal from her Roth IRA after December 31, 1999 and anytime thereafter. She met the age requirement on November 15 1999 but because the holding period was not met, she has to wait until the year 2000 to make qualified distributions. However, based on the ordering rules and the amount of the distribution, Flo can control the tax effect.
In the year 2000, upon advice of his tax advisor, Flo decides to convert more of her traditional IRA to a Roth IRA. The five-year period starts all over again for this conversion. But this time Flo is already 59 ½.She can withdraw the conversion piece tax free and penalty free at any time. The five-year rule does not apply to that.
If she was 50 at the time of the Roth conversion, Flo would have to wait five years and age 59 1/2 before being able to withdraw penalty free and tax free.
If Flo is under age 59 1/2 at the time of the conversion, she can withdraw penalty free as soon as she reaches 59 ½, but she will be taxed on Roth IRA earnings if she withdraws them before five years are up. If she is careful, the five-year period will be met before she ever touches Roth IRA earnings. Remember, Roth IRA earnings are the last out of the account in the ordering rule pecking order.
Tax Return Extensions-Aiding the Decision to Defer Tax
There is some flexibility in determining whether to make the election to defer tax until 2011 and 2012. A taxpayer can file an extension for the 2010 return and wait up to and including October 15, 2011 to decide whether to defer or pay the tax entirely on the 2010 return. Any taxpayer, whether low income, middle income or wealthy, can use this flexibility. By waiting until October of 2011, the tax rate picture for future years could be fairly clear.
Partial Conversions-Controlling the Marginal Rate of Tax
Partial conversions are permitted. There is nothing in the tax law that says a conversion has to be 100% of a traditional IRA account balance. There is nothing in the law that limits the number of conversions that can be done. By using partial conversions, taxpayers and their advisors can exercise control over the amount of taxable income and the marginal rate at which the conversion will be taxed.
Example:
Bill and Melinda Gatefloggin earned $1,000,000 in 2008, but in 2009 their company, Semihard Technology, lost $2,000,000,000 (that’s $2 billion for those of us who have never seen nine zeros after a number) and they have no income. It is not expected that things will turn around until 2011. Therefore, 2009 and 2010 would be ideal years to convert some or all of their traditional IRA, worth about $276,380, after suffering an enormous decline due to poor investment advice from their investment advisor, Hank Maduffer.
Unintended Consequences of Conversions
Taxpayers and their advisors need to consider the effect that additional income will have on itemized deductions, medical expenses, and various tax credits including the child tax credit. The additional income may cause the alternative minimum tax to come into play, denying deductions for state and local taxes and miscellaneous itemized deductions, among other effects.
Parents of college students may find financial aid reduced or eliminated because of a Roth IRA conversion. The reduction should not be permanent. The parents will have to appeal any award letters to the financial aid officer, pointing out that the Roth IRA funds are not available for college and should be excluded as retirement funds.
Large conversions may cause penalties for underestimation of tax. If estimated taxes are being paid, taxpayers and their advisors should be sure one of the three exceptions (from underpayment penalties) are met for the year of conversion. If withholding taxes are the exclusive source of paid-in taxes, taxpayers and their advisors should be careful to see that the withholding meets one of the three exceptions. If it is found that withholding and estimated taxes for the conversion are not enough, consideration must be given to the amount and timing of such payments.
Paying the Roth Conversion Taxes From non-IRA sources
As a general rule, the source of funds for payment of the taxes on conversions should come from non-IRA sources. Using IRA monies to pay the conversion taxes means distributions must be made from taxable IRAs, causing additional taxes and reducing IRA balances that should be kept for retirement. This should be avoided at all costs. Taxpayers and their advisors must consider whether there is adequate available cash from other sources to fund a conversion. If not, the conversion should be postponed. Under present tax law, there is no cutoff date for conversions.
Example:
Stephen Wonder, bookkeeper and entertainer for Ernie Maduff, has a $20,000 IRA he would like to convert. However, Ernie was recently indicted for grand larceny, his company is in receivership, and Stephen is out of a $50,000 job. He has only $2,000 in savings. Stephen probably should wait on this IRA conversion.
Recharacterizations
Roth IRA conversions rules offer taxpayers an opportunity to reverse the decision made to convert after the fact. After taxpayers and their advisors review the valuation of the account and any tax rate changes, the conversion can be reversed by moving the Roth IRA money back to the traditional IRA account. The deadline to accomplish this “do-over” is October 15th of the year following the year of conversion.
Example:
Johann Smuthaggen converts $100,000 of his traditional IRA to a Roth IRA on December 1st 2009 and reports the income in 2009 (he had no choice) and pays the extra $30,000 tax in April 2010. By September he finds that the value of the stocks in the account have declined to $80,000. Johann can move the stocks in the account back to the traditional IRA, amend his 2009 return, and recoup the $30,000 in tax.
In the example above, Johannn can wait 30 days from the date he recharacterized the Roth IRA and do a Roth IRA conversion in November or December of 2010, or whenever the 30 day wait period is up. Johannn could convert the same amount…$100,000 if he wishes, or he can convert the $80,000. In this example, Johann and his advisors can decide if they wish to elect to report the conversion in 2011 and 2012.
Recharacterization is not a one-time event. In the example, Johann could recharacterize again in 2011 if the account fell further or Johann and his advisors decided that the marginal tax rates in either 2010, 2011, or 2012 were too high.
Using Separate New Roth Conversion Accounts
As discussed, conversion offers a lifetime opportunity to take advantage of one of the biggest tax breaks in the Internal Revenue Code. The question is how many accounts should be used. Does it makes sense to put equities in one Roth IRA conversion account, bonds in another Roth IRA conversion account and cash in a third Roth IRA conversion account. Taxpayers and their advisors will want to look at this opportunity.
Separate accounts make sense when the equity allocation is significant. If the equity valuation falls, that account only can be recharacterized while the other accounts stay converted. Value plays a part in this decision, but also account management plays a part as well. If accounts are well managed, 20% to 30% declines in short period may be preventable.
Conversion from Employer Plans
The Pension Protection Act of 2006 which took effect in 2008 allows an employee to roll a distribution directly into a Roth IRA without having to first go through a traditional IRA account. The employer plan must contain language that allows a distribution to a traditional IRA (most do), and the taxpayer must be otherwise eligible to do a Roth IRA conversion (not married filing separately and under $100,000 of modified adjusted gross income). The purpose of the change was to eliminate the paperwork created by the intermediate step of setting up a rollover IRA account, accepting the rollover, transferring to a Roth IRA account, and closing down the rollover IRA account.
No Conversions for Non-spouse Inherited IRAs
It does appear that the non-spouse who inherits a traditional IRA cannot convert it to an inherited Roth IRA. On the other hand, a non-spouse who inherits a qualified retirement plan such as a 401(k), 403(b) or a 457 can convert to an inherited Roth IRA. That seems unfair. The two rules do not make sense, but that is how I understand the rules. A spouse can convert an inherited IRA to a Roth IRA. Here, I am just talking about a non-spouse. A non-spouse is anyone other than a spouse (child, grandchild, cousin, stepchild, etc.)
As you know or should know, inherited IRAs must be kept in separate accounts from other IRA accounts until used up.
Will the Congress Tax Roth IRAs?
Probably someday. Right now, though, there are many retirement accounts….SEP IRAs, traditional IRAs, 401(k)s….that taxpayers and their advisors will consider converting before retirement dates. Therefore, the IRS will collect taxes long before they otherwise would and perhaps at a high marginal rate, if the present value computations indicate to taxpayers and their advisors that it is a good strategy to pay upfront. In looking at a change, Congress would have to deal with the issue of how to treat the after-tax dollars that now go to fund Roth IRAs. Double-taxing Roth IRAs would not be a workable solution. Even if Congress decides to change the rules, there’s a very good chance that present Roth IRAs would be grandfathered because that’s the history of tax law changes.
The Strategy if the Government Taxes Roth IRAs
What if the government passed a law stating that distributions of past earnings would be grandfathered as taxfree, but that distributions of future earnings would be taxed. Unthinkable, because that would freeze the government’s source of upfront tax revenue. Conversions could come to a streeching halt. But, the government has not always made wise tax law, so a strategy is needed in this worst case scenario.
A strategy to combat the reversal of Roth IRA benefits would be to close the Roth IRA account by selling all appreciated assets in the Roth IRA account and then withdraw all remaining stocks, mutual funds, sales proceeds of the appreciated assets, and remaining cash. This withdrawal would presumably be taxfree because rarely if ever does the government make new law retroactive. Then the cash and depreciated assets/mutual funds would be placed in a taxable account. The asset allocation would then favor low or no dividend- paying stocks. Bonds and bond mutual funds would still have to be part of the allocation, but perhaps at a reduced percentage.
Taxpayers who have low risk tolerances and their advisors could deal with this potential legislation by lowering the amount of the Roth IRA conversion and managing taxable income so that the marginal tax rate is as low as possible. By keeping the upfront tax cost as low as possible, the “damage” from a law change will be minimized.
Example:
Ricard Schlosseinberger managed his taxable income for 2009 before his Roth IRA conversion to be negative $15,000. His planned conversion of $30,000 would cost $1,400 in tax or 4.67% of the $30,000. That’s a pretty safe bet. The taxfree income in one year in the Roth account would be at least $1,400.
How to Know If a Conversion is Worthwhile
If you go to Google or Yahoo or Bing and type in “IRA Conversion Software” you are bound to hit some sites that assist in computing the tax cost and value of converting. Fidelity also has an IRA Conversion tool. I have not tried any of these because my firm has the Brentwood Software IRA Conversion tool which gives more reports than could possibly be absorbed in a weekend. But one report outweighs them all, in my opinion, and that is the net asset value plus distributions at the end of the last year when the Roth inherited IRA runs out of money due to distributions. So far, my real-life tests have been positive by a wide margin and the conversion has been recommended.
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