Advanced Topics In Roth Conversions

Advanced Topics in
Roth Conversions
9 Critical Issues for Real World Clients

www.SoundViewAdvisors.com
Advanced Topics in Roth Conversions
1

An Overview
• Recapping “the basics”
• Examples for typical client profiles
• If only it were that simple – real world
complications
• Real world conversion: nine critical issues

2

A Brief History

3

Traditional IRAs
• ERISA (1974)
– $1,500 Deductible Contributions
– Only if not covered by an employer plan
• ERTA (1981)
– Eased restrictions
– Raised max contribution to $2,000
– Spousal IRA ($250 for nonworking spouse)
• Tax Reform Act (TRA-1986)
– Reversed expansionary trend by phasing out deductibility

4

5

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

6

And in 1997 –
Roth Turned The IRA Upside Down

7

Vive la Difference

8

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)

9

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

10

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

11

Distribution Distinctives
Note: Roth IRA ≠ Roth 401k, etc.

Traditional IRA Roth IRA
• Taxable as “ordinary” • Tax-free (if Roth open
income (any basis 5+ tax years, and
reduces taxation) >59.5)
• RMDs during • No RMDs during
participant’s life participant’s life
• Ordering rules follow • Contributions first
“cream in the coffee” (then conversions,
rule then earnings)

12

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

13

What if the distribution isn’t qualified?

A: Turn to the “Ordering Rules”

14

Roth Ordering Rules in Detail
1. All direct contributions are aggregated
2. Each “rollover” (conversion) contribution
separately on FIFO basis for ordering &
penalty rules
– All conversions within same year are aggregated
3. 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
15

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

16

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
17

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

18

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

19

Basic
Principles
Applicable to
the
Conversion
Analysis

The Old Switcheroo…
20

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 5th grade (or earlier!)
• Associative means you can group the
numbers in any way without changing the
answer
–AXBXC=D
–AXCXB=D
21

Example
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

22

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”

23

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”

24

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
25

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.

26

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 include an allowance for state estate taxes paid
• So, it’s more tax-efficient to incur an income tax before
incurring an estate tax

27

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.

28

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

29

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

30

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
31

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

32

So, Who Wins?

33

Key Factors -
• Rates
• Timing of distributions
• Transfer taxes
• Source of funds for tax payment
• Interaction with broad financial situation
– Early retiree
– Charitable intent
– NOL
34

Roth Conversion Factors
&
Typical Client Profiles

35

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
36

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

37

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

38

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

39

If Only It Were That Easy…

Planning Under Uncertainty

40

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

41

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

42

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
43

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……
44

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
45

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?

46

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.
47

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!
48

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.

49

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!

50

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.

51

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
52

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

53

Further Uncertainty
• 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.
54

Further Uncertainty
• 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.

55

Dealing with Uncertainty
• In our analysis
• In our approach

56

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

57

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
58

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!

59

Conversions in the Real World

Practical Considerations

60

9 Critical Issues / Considerations
1. Recharacterization – the basics
2. Recharacterization on steroids: segregation by asset
class
3. Pay now or pay (a bit) later
4. After-tax money
5. Who can convert / what can we convert?
6. Planning linkages (Medicare premium, Social Security
taxation, financial aid loss, etc.) (example)
7. Tax planning opportunities (matching up big
deductions with big income, etc.) (example)
8. Portfolio management: allocation/location Issues
9. Estate & probate issues

61

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)

62

Recharacterizations
Timeline

63

“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 15th) 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
64

Why Might We Recharacterize?
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 $100,000 $125,000 $75,000
Recharacterization Date
Effective Tax Rate on 25% 20% 33%
Conversion

65

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
66

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
67

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

68

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
• Pertinent rule: minimum 30 days later
• Pertinent rule: minimum 30 days later
69

Roth Segregation Strategy
• Definition – create multiple Roth IRAs to
fully utilize the ability of recharacterizing if
the converted asset(s) go down in value.

70

• Two primary uses:
1. 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
2. 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
71

• 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 15th of the following year

72

• 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 15th of
the year following the conversion year

73

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

74

• 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
75

• 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.
76

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
77

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?

78

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%)

79

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 15th 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

80

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.
81

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)

82

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

83

“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
84

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!

85

So Much for Cream in the Coffee!
We Have a “Centrifuge”

86

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…

87

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
88

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

89

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

90

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

91

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

92

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 "combined income”

93

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

94

Are these effective tax rates
what you expected?

95

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

96

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
97

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
98

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

99

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

100

Asset Allocation/Location

101

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
102

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
103

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

104

Wrapping
Up

105

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
106

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

107

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

108

Advanced Topics In Roth Conversions

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