Roth IRA

Roth IRA Conversion Insights – Part 1 of 2

Last week’s post completed a six-part series discussing the three primary benefits to be derived from a Roth IRA conversion: (1) elimination of taxation on 100% of the growth of Roth IRA conversion assets, (2) elimination of exposure to required minimum distributions on traditional IRA funds converted to a Roth IRA, and (3) potential reduction in taxation of Social Security benefits.

Part 6, the finale of the series worked through two comprehensive scenarios – one with no Roth IRA conversion and a second with a Roth IRA conversion – to determine which one was projected to result in more total investment assets throughout the life of the scenario. As emphasized in the post, the results of the two scenarios cannot be generalized and used as the basis for determining whether a Roth IRA conversion is appropriate in a particular situation. Furthermore, a detailed analysis needs to be prepared by a retirement income planner for every potential Roth IRA conversion situation.

Having said this, there are several insights to be gained from analyzing the two scenarios that can be applied to any potential Roth IRA conversion analysis. This post will discuss the first three with next week’s post addressing three others.

Actual Results are Likely to be Different Than Projected Results

By far, the most important insight to keep in mind going into any Roth IRA conversion analysis is that actual results are likely to be different than projected results. Without listing them individually, the multitude of assumptions that must be considered and the interaction between them is the reason for this. Contributing to the complexity and uncertainty is the lengthy timeframe that needs to be considered in most situations with the associated potential for multiple changes in the realization of each assumption. In addition, the timeframe needs to include spouses’ and other potential beneficiaries’ lifetimes when applicable.

Multi-Year Income Tax Planning is Critical

When I read, or attend presentations, about Roth IRA conversions, the importance of marginal income tax rates in the year(s) of conversion(s) and the years of distribution from traditional IRA accounts is often emphasized as one of the key factors in a Roth IRA conversion analysis. When I entered the tax profession in 1980 and the top marginal federal income tax rate was 70%, did I know that by 1987, the top rate would be slashed to 38.5% and would stay within three percentage points of this rate for at least the next 25 years with today’s top rate of 35% scheduled to remain in effect through 2012? While a strong argument can be made that a tax increase is inevitable given our huge federal budget deficit, no one knows for certain when this will occur or what future tax rates will be.

It’s not just about tax rates. Comprehensive multi-year income tax planning on both the “front-end” and “back-end” is critical to the success of any Roth IRA conversion analysis. Keeping in mind that a Roth IRA conversion generally shouldn’t be a one-year event, “front-end” planning should include preparation of multi-year income tax projections to determine how much of one’s contributory IRA should be converted and in which years. On the “back-end,” multi-year ongoing projections need to analyze the impact of projected required and discretionary distributions from contributory and Roth IRA accounts as well as nonqualified investment accounts in meeting one’s projected financial needs. Each “back-end” projection should include an analysis of taxable Social Security benefits. Finally, both “front-end” and “back-end” income tax projections need to consider all projected sources of income, losses, and deductions in each year.

Growth of Roth IRA Conversion Assets is Dependent on Roth IRA Conversion Timing

The number one benefit to be derived from a Roth IRA conversion, i.e., elimination of taxation on 100% of the growth of Roth IRA conversion assets, is dependent upon the timing of a Roth IRA conversion relative to stock market valuation assuming that a sizeable portion of one’s Roth IRA conversion portfolio is equity-based. In order to realize this benefit, by definition, there needs to be an increase in the value of one’s Roth IRA from the date(s) of conversion(s) to the future comparison date.

With the Dow Jones Industrial Average increasing by approximately 1,000 points, or 8%, in the past month to finish at 12,811 on Friday combined with a 100% increase, or doubling, from its close of 6,440 on March 9, 1999 a little over two years ago, the determination of the timing of a Roth IRA conversion is more difficult than it was last year at this time. Recharacterization, (see the April 19, 2010 post, Recharacterization – Your Roth IRA Conversion Insurance Policy) is a strategy that’s available for retroactively undoing a Roth IRA conversion that was done prior to a market decline if it’s implemented during a specified limited time period following a conversion.

Roth IRA

Year of the Extension

“Year of the Conversion,” the initial post on January 11th of this year kicked off a weekly series of informative posts regarding a tax/financial planning technique that was authorized by Congress beginning in 1998. As explained in “Year of the Conversion,” from 1998 through 2009, only taxpayers with modified adjusted gross income of less than $100,000 were eligible to convert a traditional IRA to a Roth IRA. Beginning in 2010, the $100,000 income threshold has been eliminated and, as a result, anyone who has a traditional IRA can convert part or all of his/her accounts to one or more Roth IRA accounts.

I felt it would be fitting to conclude the Roth IRA conversion series with “Year of the Extension” to remind anyone who has done a conversion in 2010 or is still planning on doing one in 2010 or in future years of a very important, and often overlooked, step in the Roth IRA conversion process. Unlike most tax planning techniques whereby once you’ve implemented the technique, it’s a done deal and you simply need to report the historical transaction on your income tax return, Roth IRA conversions need to be monitored for up to 22 months following the conversion date depending upon when the conversion occurs.

Given the fact that (1) the amount of income that you’re required to report on your income tax return is based on the value of the portion of your traditional IRA that you convert on the day of the conversion and (2) there exists the possibility that there can be a decline in value following the conversion, IRS has provided us with an insurance policy for this situation. Through a process referred to as recharacterization, you’re provided with a window of opportunity to undo your Roth IRA conversion and the associated income that you’re otherwise required to report on your tax return.

The April 19th post, “Recharacterization – Your Roth IRA Conversion Insurance Policy,” explains this technique, including the amount of time that must pass before you can do another Roth IRA conversion. Basically, as explained in the post, you have until April 15th following the year of your conversion, or until October 15th if you applied, and are approved, for an extension, to undo your Roth IRA conversion.

In order to minimize the income tax liability associated with your conversion, you need to monitor the value of your Roth IRA following the date of your conversion through April 15th following the year of your conversion to determine if you should recharacterize your conversion. Furthermore, if you haven’t done a recharacterization by April 15th of the year following the year of your conversion, it’s highly advisable to apply for an extension of time to file your income tax return. By doing this, you will extend your potential recharacterization timeframe by an additional six months until October 15th.

It’s important to keep in mind as always whenever you file an extension that 100% of your income tax liability must be paid by April 15th since an extension is only an extension of time for filing your return. It doesn’t extend the time for payment of your tax liability.

Unless you’re fortunate to either have enough basis in your traditional IRA or losses and/or deductions to offset the income attributable to your Roth IRA conversion so that you will incur minimal or no income tax liability attributable to your Roth IRA conversion, you need to monitor the value of your converted Roth IRA until at least April 15th following the year of your conversion and possibly for an additional six months until October 15th. If you’re in this situation, always remember to file an extension application by April 15th following the year of your conversion.

Roth IRA

Considering a Partial 72(t) Roth IRA Conversion? – Tread Lightly

The topic of this week’s blog post is one which, quite frankly, doesn’t pertain to very many people. You may be wondering why I’m writing about it if this is the case. Besides bringing the topic to the attention of those who may be affected by it, the main reason I’m writing this post is to provide interested readers with an example of a tax planning strategy that, while it doesn’t run afoul of any IRS rules, hasn’t been officially blessed by IRS.

As with many of my blog posts, this one was inspired by one of my clients. Mr. and Mrs. R., who are retired, aren’t yet receiving Social Security benefits, and derive the majority of their income from Mrs. R.’s 72(t) IRA and two nonqualified term certain annuities, a sizeable portion of which is nontaxable.

For those of you unfamiliar with a 72(t) IRA, some brief background. Generally you must wait until age 59-1/2 to begin taking distributions from an IRA, otherwise you’re subject to a 10% premature distribution penalty in addition to any income tax liability on your distributions. IRS has carved out an exception to this rule whereby you won’t be subject to the 10% penalty if you receive a series of substantially equal periodic payments, or “SOSEPP,” from your IRA for the greater of five years or until you reach 59-1/2. A 72(t) IRA account is a traditional or a Roth IRA account from which a SOSEPP is being made.

While Mrs. R has been taking her SOSEPP for five years, she’s still about a year and a half from turning 59-1/2. If Mrs. R. discontinues her SOSEPP before she turns 59-1/2, IRS would consider this to be a modification of her SOSEPP. As such, Mrs. R. would be subject to a 10% premature distribution penalty on future distributions from her IRA. Furthermore, the 10% penalty would also be applied retroactively to all of the distributions she has already taken from her 72(t) IRA.

In addition to their 72(t) IRA and nonqualified annuity distributions, my clients recently sold a rental property at a loss of $26,000. After reducing their adjusted gross income by various itemized deductions, they were projected to have a 2010 taxable loss of approximately $25,000. While this would result in no income tax liability, without further income tax planning, this would be a potentially wasted opportunity to recognize additional income and still pay no income taxes.

How could my clients recognize additional income? While they could potentially sell securities at a gain in their nonretirement account, this would be offset by a sizeable capital loss carryover. The other option was to do a Roth IRA conversion of Mrs. R.’s 72(t) IRA. IRS regulations permit a full Roth IRA conversion of a 72(t) IRA provided that the IRA owner continues his/her 72(t) distributions from the Roth IRA account following conversion.

Since the value of Mrs. R’s. 72(t) IRA was approximately $280,000, the potential income tax liability attributable to a full 2010 conversion of Mrs. R.’s 72(t) IRA to a Roth IRA couldn’t be justified based on my client’s current and projected multi-year income tax planning even with splitting the reporting of Mrs. R.’s conversion income between 2011 and 2012. I calculated that Mrs. R. could do a partial conversion of $50,000 without incurring any income tax liability due to my client’s ability to use a net operating loss carryover that they couldn’t otherwise use in 2010. Furthermore, Mrs. R.’s conversion amount could be as much as $70,000 before my client’s marginal income tax rate would exceed 15%.

Since IRS has endorsed the full conversion of a 72(t) IRA to a Roth IRA, it would seem that there should be no issue with a partial conversion so long as the 72(t) payments continue following the conversion. Logically, the post-conversion 72(t) payment amount should be paid from both the original 72(t) IRA and the new Roth IRA accounts based on the allocation of the relative values of the two accounts. The problem is that IRS has provided no guidance on partial Roth IRA conversions of 72(t) IRA accounts, including the allocation of post-conversion 72(t) payment amounts.

Given this situation, while it isn’t logical, IRS could potentially challenge a partial Roth IRA conversion of a 72(t) IRA. If IRS were to prevail on this issue, as previously stated, future, as well as retroactive, 72(t) distributions would be assessed a 10% premature distribution penalty. IRS would also assess interest on any assessed penalties.

After consulting with Natalie Choate, a well-known attorney who specializes in estate planning for retirement benefits, I recommended to my clients that they consider doing a partial Roth IRA conversion of Mrs. R.’s 72(t) IRA in 2010, file a 2010 income tax extension application, and plan on recharacterizing, or undoing, Mrs. R.’s partial Roth IRA conversion by October 15, 2011, the extended due date of Mr. and Mrs. R.’s 2010 income tax returns, in the event that IRS doesn’t provide definitive guidance on partial Roth IRA conversions of 72(t) IRA’s by this date. (For an explanation of the recharacterization process, please see Recharacterization – Your Roth IRA Conversion Insurance Policy.)


Recharacterization – Your Roth IRA Conversion Insurance Policy

One of my clients who was 80 years old converted a portion of her traditional IRA to a Roth IRA early in March, 2009 when the Dow Jones Industrial Average (DJIA) had just climbed over the 7,000 mark after declining to an intraday low of 6,440 on March 9th. With the DJIA increasing by 4,000 points, or 57%, to 11,000 recently, and assuming it stays at this level, at least 57% of the value of my client’s IRA at the time of conversion that would have eventually been taxed had my client not done her conversion will permanently escape income taxation provided the market remains above 11,000 and she takes no distributions from her Roth IRA for five years from the date of her conversion.

With the market up almost 60% in a little over a year, many people are wondering if this is a good time to do a Roth IRA conversion. What happens if you do a conversion, you’re not as fortunate as my client, and the market does an about-face, descending below 10,000 again? This may not make much difference if the assets that you converted are not directly market-sensitive such as fixed income instruments. But what if your Roth IRA conversion assets instead consist of a diversified portfolio of small-, mid-, and large-cap individual stocks, mutual funds, and exchange-traded funds? That’s a different story.

Forgetting about the fact that you’re generally required to wait at least five years from the first day of the year in which you do a conversion to take a distribution from your Roth IRA in order to avoid a potential 10% tax on early distributions (see my April 5th blog, The 5-Year Freeze) and that there is a strong likelihood, although no guarantee, that the market will increase to at least the 11,000 level again within five years, IRS has created an out for you. You can make an election to reverse your Roth IRA conversion through a process called recharacterization.

Basically, you have until April 15th following the year of your conversion, or until October 15th if you applied, and were approved for, an extension of filing, to undo your Roth IRA conversion. You must transfer the amount of your Roth IRA conversion plus earnings thereon from your Roth IRA account back to your traditional IRA account via a trustee-to-trustee transfer by the applicable date.

Let’s suppose you do a recharacterization because the stock market has declined significantly since the date that you did your Roth IRA conversion and you want to do another Roth IRA conversion to potentially minimize your income tax liability attributable to your conversion while the market is still down. How long must you wait to do this? The amount of time that you must wait to do another Roth IRA conversion using the same traditional IRA depends on the timing of your recharacterization. If you do a Roth IRA conversion and recharacterization during the same year, you must wait until the following year to do another conversion. If, on the other hand, you do your recharacterization during the year following the year you did your conversion, you must wait 30 days following your recharacterization date to do another conversion.

As an example, suppose you did a Roth IRA conversion on April 12, 2010 when the market was above 11,000. The market continues to increase for a while and then it slides back below 10,000 at the end of 2010. Assuming that you file a 2010 income tax return extension application and your application is approved, you would have until October 17, 2011 (October 15th falls on a Saturday) to reverse your Roth IRA conversion through a recharacterization. Assuming that you don’t do a recharcterization in 2010, you file an extension application for filing your 2010 income tax returns, and you do a recharacterization by October 17, 2011, you would need to wait 30 days following the date of your recharacterization to do another conversion using the same traditional IRA account.

Through the magic of recharacterization, your Roth IRA conversion is insured until at least April 15th of the year following the year of your conversion in the event that the value of your Roth IRA decreases significantly from its value on the date of conversion. Like all insurance policies, beware of the exclusions, the most significant one being that your ability to recharacterize will end on April 15th of the year following the year of your conversion or October 15th if you have filed, and been approved for, an extension of time to file your income tax returns.