The ability to re-characterize an IRA to a Roth has always been available to people below the $100,000 gross income level. You will have a tax liability on the conversion amount which is due by April 15th of the following year. You will also have to wait five years and be over the age of 59 ½ before you can access the principal and growth tax/penalty-free.
What has changed is beginning January 1, 2010, any household at any income level can convert a traditional IRA to a Roth IRA. You will have to pay taxes on the conversion at your current rate. For example, if you are at the 25% tax level, on a $100,000 conversation you will be taxed $25,000. But if you convert in 2010, you’ll have the opportunity to recognize half the income in 2010 and the other half in 2011. In other words, you will have two years to pay the taxes on the conversion. The five year and 59 ½ rule will apply to the conversion.
Considerations
For many people, this is a great one-time opportunity to create future tax-free distributions. However, the conversion is not for everyone. Things to consider:
If you expect your tax rate to decline in the future, then it would make sense to forgo the conversation and just pay the tax on the IRA distribution. The closer you are to retirement and to taking withdrawals, the stronger this argument becomes. There is no guarantee however that your tax rate or tax liability will decline in the future even with a reduced income. With huge government spending, the deficit is growing rapidly which means some taxes will, in the future, be going up. Or the government could reduce the allowable deductions we now enjoy. Either way, the end result will effectively increase your tax rate. Most financial analysts expectitax rates to increase at some point in the future.
You should have the money available to pay the tax without raiding the IRA to do so. Using the IRA to pay the taxes is self-defeating. This may subject you to a 10% penalty and you would lose the tax-free growth on the money sheltered within the account. The need to pay the tax sooner and in much larger lumps is the major disadvantage of the IRA to Roth conversion. Fortunately, the conversion is not an all or nothing proposition. You can convert some of the IRA assets to a Roth while leaving the balance in the IRA. In other words, you can convert the amount for which you have the money on hand to pay the tax, not the entire IRA amount.
One idea would be to increase your payroll withholdings beginning in January 2010 and running through December 2011. Work with your CPA to estimate the total tax overpayment and then use that amount to pay the conversion tax. Remember you have two years to pay the tax, but the conversion goes to work for you immediately.
The government may attempt to touch Roth accounts. The end result is the government could realize a huge influx of income (taxes) over the next two years at the expense of future administrations. Future administrations may attempt to recoup some of the ‘lost’ revenue by taxing Roth withdrawals. This is not likely as it would be double taxation but they could remove the tax-free ability to pass the account onto your heirs. Or they could decide to tax the Roth earning. This would be an unpopular decision but there may be other creative ways the government could tap the Roth accounts. Although possible, I don’t think the government will attempt to touch Roth accounts in the foreseeable future.
The Best Approach
The best overall approach may be to transfer as must as you can afford into your Roth in 2010 and leave the balance in your IRA. You can always re-characterize portions of your IRA to your Roth at a future time if your gross income is less than $100,000. The only 2010 urgency is the removal of the gross income restriction and having the ability to spread the tax liability over a two year period. And then again, the government may extend the program or a modified version into 2011 and beyond.
All IRA to Roth re-characterizations are taxable events and will have to meet the five-year rule before the distributions will be tax-free. If you have a number of years before retirement, this can be a good retirement planning. If you’re already over 59 ½, you can take IRA distributions now, pay the tax and place the distribution in your Roth.
The Divide and Conquer Strategy
For most people, a partial IRA conversion is the best option because of the tax liability involved. Fortunately, creative planning can help you get the most mileage from a partial conversion. If you place the full conversion into a single Roth account, the tax effects of losses and gains are proportional to the account. But if you split the IRA conversion into multiple Roth accounts each with a single asset class, then you can use re-characterizations to take maximum advantage of the tax break. This strategy is available to you every year.
A Step by Step Example
Assumptions: You are in the 25% tax bracket and have $200,000 in an IRA. You have $5,000 in cash which you are willing to use to pay the tax on the conversion.
Step 1. January 2010: Convert the $100,000 in the IRA into five separate Roth accounts with each with $20,000 and invested in a single asset class. Asset classes could be high yield bonds, emerging markets, REITs, domestic small caps and foreign stocks. This is a temporary allocation and other asset classes could be used. The idea to achieve hyper-returns from one or more asset classes.
Step 2. April 15, 2011: Pay the $5,000 tax but file for an automatic extension on the return. This will give you until October 15, 2011 to file the final return.
Step 3. October 1, 2011: Review each Roth account and decide which one to keep. Then re-characterize the other four back to the IRA before October 15, 2011. The end result is you paid the $5,000 tax on the conversion, enjoyed 21 months of earnings and started the clock on tax-free withdrawals in January 2010.
What if all five Roth accounts decline in value? Simple, just re-characterize all five back to the IRA, file the tax return and get a refund of the $5,000. After 31 days, or at the beginning of the year after the original conversion, whichever comes later, you can once again re-characterize the traditional IRA to Roth IRAs, but with a lower tax liability. This strategy will provide you with a lot of tax planning flexibility.
Piles of Paperwork
The above strategy will require accurate record keeping. You will need to track the IRA and Roth accounts very carefully and document the money movement. Avoid using a single Roth account as the proportional allocations will be difficult to track.
If you want to push back portions of a combined Roth, the custodian will have to determine the amount of the portion conversion and any net income (or loss) allocable to the conversion. If the Roths are combined, you may be required to make up any losses. This is self-defeating so the easiest solution is to create separate Roth accounts.
The Roth you decide to keep should be re-allocated to a more effective diversification. After the five year waiting period, this Roth can be merged into the ‘master’ Roth without penalty.
The Divide and Conquer strategy can be used every year. The ideal situation would be to have five Roth accounts in the pipeline with one “graduating” each January and merged into the master Roth. Use remaining IRA amounts to create five more Roths. In December of the same year, pick the one you like best and send the rest back to the IRA. Repeat in January.
You can see the importance of accurate paperwork because you will be tracking up to 10 Roth accounts and the IRA account. With separate Roth accounts for each year, the paperwork trail will be easier to manage.
Summary
The upcoming Roth IRA conversion can be a golden opportunity for the right person. But it’s not for everyone. Feel free to contact me and I can help you with the pros and cons for your specific situation.
David Snellen
Registered Investment Advisor
USA Living Financial Group
954-302-3628
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