Tag: traditional IRA

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Roth IRA

Year of the Extension

Retirement Income Center

“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.

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Roth IRA

Roth IRA Conversion – Analysis Paralysis? – Part 1 of 2

Retirement Income Center

As is evident by the sheer number of blog posts to date about Roth IRA conversions – 33 – there’s a lot of things to consider when deciding whether a Roth IRA conversion makes sense for you. These include, but are not limited to, the following questions:

  • Should you do a Roth IRA conversion?
  • How much traditional IRA should be converted?
  • In which year(s) should a conversion be made?
  • Should you employ a multi-year conversion strategy, and, if so, what’s the best plan for you?
  • At which point during a particular year should a conversion be done?
  • Does it make sense to do multiple conversions in a single year?
  • Even though the income from a conversion in 2010 can be deferred to 2011 and 2012, should you do a conversion in 2010?
  • If you do a Roth IRA conversion in 2010, should you go with the default of reporting 50% of the conversion income on your 2011 tax returns and 50% on your 2012 returns or should you instead make an election to report 100% of your conversion income on your 2010 income tax returns?
  • Will your income tax rate be higher or lower than what it is now when you take distributions from your IRA accounts?
  • Which assets should be converted?
  • Should you set up multiple Roth IRA conversion investment accounts?
  • Is the current primary beneficiary of your traditional IRA a charity?
  • Are there retirement plans available for conversion other than active 401(k) plans?
  • What is the amount of projected income tax liability attributable to a potential conversion?
  • When will the tax liability attributable to the conversion need to be paid?
  • What sources of funds are available for payment of the tax liability?
  • Will withdrawals need to be made from the converted Roth IRA within five years of the conversion?
  • Do you have a life expectancy of five years or less with no living beneficiaries?
  • Do your itemized deductions and personal exemptions exceed your gross income such that you can convert a portion, or perhaps all, of your traditional IRA to a Roth IRA without incurring any income tax liability?
  • Do you own a rental property with a large passive activity loss carry forward that you can sell and do a Roth IRA conversion while incurring minimal or no income tax liability?
  • Is there a net operating loss that you can use to offset Roth IRA conversion income?
  • Is there a large charitable contribution available from the establishment of a charitable remainder trust that can be used to offset income from a Roth IRA conversion?
  • What is the basis of your traditional IRA, i.e., how much of your IRA has come from nondeductible IRA contributions or qualified retirement plan after-tax contributions?
  • Are you a surviving spouse in a low tax bracket who isn’t dependent on your IRA and one or more of your children are in a high income tax bracket?
  • What are the years and amounts of your projected required minimum distributions with and without a Roth IRA conversion?
  • What is the amount of projected taxable Social Security benefits that can be reduced by doing a Roth IRA conversion?
  • Do you have a SEP-IRA that can be converted to a Roth IRA?
  • Do you have a dormant 401(k) plan that can be converted?
  • How will a Roth IRA conversion affect financial aid qualification?
  • Will your Medicare Part B premium increase if you do a Roth IRA conversion?
  • If you do a Roth IRA conversion in 2010, will your Medicare Part B premium increase in more than one year?
  • What are the income tax consequences of a partial 72(t) Roth IRA conversion?
  • Should you not do a full Roth IRA conversion and instead leave funds in your traditional IRA for future nondeductible IRA contributions?

Feeling overwhelmed? Read Part 2 next week.

Categories
IRA

Doing a Roth IRA Conversion? – Leave the Door Open

Retirement Income Center

You’re standing on the edge of the 10-meter diving platform ready to take the plunge into Roth IRA conversion waters, about to transfer 100% of your traditional IRA to a Roth IRA. Before you take that final step, there’s one more thing that you should consider if you’re still working or planning on working in the future and your income exceeds certain limits.

If you’re converting your entire traditional IRA to a Roth IRA, it doesn’t have to be, and in many cases shouldn’t be, the last Roth IRA conversion that you will do. In 2010, if you’re single and your modified adjusted gross income (“MAGI”) exceeds $120,000 or if you’re married and your MAGI exceeds $177,000, you’re prohibited from making direct contributions to a Roth IRA. It’s important to keep in mind that if your income doesn’t exceed these limits and you make a contribution to your Roth IRA, the maximum allowable amount is currently $5,000 or $6,000 if you’re 50 or older, and, furthermore, your contribution isn’t deductible.

While your income may limit your ability to make direct contributions to a Roth IRA, you may still make indirect contributions via a two-step process. In order to implement this strategy, you need to have a traditional IRA account in place. I recommend to all of my working clients who are considering full conversion of their traditional IRA’s to Roth IRA’s to keep one of their traditional IRA accounts open by leaving $1,000 in it. If you do this, even though you may be transferring 99% of your traditional IRA to a Roth IRA, you’re technically doing a partial, vs. a full, Roth IRA conversion.

Assuming that your income exceeds the specified deductible IRA contribution limits which in 2010 are $66,000 if you’re single and $109,000 if married, step one is to make a nondeductible IRA contribution to your traditional IRA account. The maximum allowable traditional IRA contribution, whether it is deductible or nondeductible, is identical to the maximum allowable Roth IRA contribution limit: $5,000 or $6,000 if you’re 50 or older.

Once you’ve made your nondeductible IRA contribution, you may immediately implement step two. Given the fact that, beginning in 2010, there are no income limitations in connection with converting traditional IRA accounts to Roth IRA accounts, step two is to complete your financial institution’s Roth IRA conversion form requesting transfer of the amount that you just contributed to your traditional IRA to your Roth IRA account. Once again, this will be a partial conversion since you generally want to leave funds in your traditional IRA account in order to keep it open for potential future contributions.

Although you have until April 15th to make an IRA contribution for the preceding year, it’s a good idea to execute this two-step process at the beginning of each year assuming that funds are available. This will get you in the habit of making sure that you implement this strategy each year, and, if done consistently over a number of years, can substantially add to the value of your Roth IRA account.

Categories
Roth IRA

Not Converting 100% of Your Traditional IRA’s? – Don’t Use All of Your Basis – Part 2

Retirement Income Center

If you haven’t yet read last week’s post, I recommend that you do so before reading this one. Last week’s post listed three types of partial Roth IRA conversion scenarios and stated that the calculation of taxable gain in scenarios #2 and 3 can be problematic when basis exists if you’re not careful. This week’s posts illustrates each of the three scenarios.

Scenario #1 – Conversion of a Portion of a Single Traditional IRA Account

Suppose you own one traditional IRA account with a value of $120,000 and basis of $100,000. If you convert 50% of the account value, or $60,000 to a Roth IRA, you would use 50% of your basis, or $50,000 to calculate your taxable gain as follows: $60,000 – $50,000 = $10,000. Your remaining unused basis would be $50,000 (total basis of $100,000 less basis used of $50,000).

Scenario #2 – Conversion of a Portion of a Traditional IRA Account Where There are Multiple Traditional IRA Accounts

For this scenario, let’s assume that you own two traditional IRA accounts, consisting of a contributory and a SEP-IRA account with the following value and basis:

Account Type

Current Value

Basis

Contributory IRA

$100,000

$ 80,000

SEP-IRA

$200,000

  

$   0

 

TOTALS

$300,000

$ 80,000

Let’s assume that you convert 50%, or $100,000, of your SEP-IRA account to a Roth IRA. What is the amount of basis that you should use to calculate your taxable gain? Is it (a) $0 (50% of your SEP-IRA basis), or (b) $26,667 (1/3 of the total basis of both of your traditional IRA accounts)?

For those of you who guessed “b,” you are correct. Per last week’s post, whenever you calculate the taxable gain in connection with a partial Roth IRA conversion, you always need to include the basis from all of your traditional IRA accounts in your calculation. Since you are converting $100,000, or 1/3 of the total value of your traditional IRA accounts of $300,000, you need to use 1/3 of the total basis of your two accounts, or $26,667 ($80,000 divided by 3), resulting in a taxable gain of $73,333 ($100,000 – $26,667).

Scenario #3 – Conversion of 100% of One of Two or More Traditional IRA Accounts

Suppose in Scenario #2, instead of converting 50% of your SEP-IRA, you decide instead to convert 100% of your contributory IRA to a Roth IRA. Your contributory IRA account has a high basis since all of the contributions to it have been nondeductible vs. 100% deductibility for all of the contributions to your SEP-IRA, resulting in $0 basis. If you convert 100% of your contributory IRA to a Roth IRA, is the amount of basis used to calculate your taxable gain (a) $80,000 (100% of your contributory IRA basis), or (b) $26,667 (1/3 of the total basis of both of your traditional IRA accounts)?

Once again, “b” is correct. As with Scenario #2, you cannot simply use the basis from the traditional IRA account that you are converting to calculate your taxable gain. When there are two or more traditional IRA accounts, you must use a pro rata portion of your basis based on the relative values of the accounts that you are converting. Since you are converting $100,000, or 1/3 of the total value of your traditional IRA accounts of $300,000 you need to use 1/3 of the total basis of your two accounts, or $26,667 ($80,000 divided by 3), resulting in a taxable gain of $73,333 ($100,000 – $26,667).

In both Scenarios #2 and #3, after doing your Roth IRA conversion, you will have remaining basis of $53,333 (total basis before conversion of $80,000 less basis used for the conversion of $26,667).

Whenever you’re considering a Roth IRA conversion, you should always follow these four steps:

  1. Take an inventory of your various traditional IRA accounts to make sure that you’re including all of them in your calculations, even those you aren’t converting. Include all of your regular, or contributory IRA accounts, rollover IRA’s, SEP-IRA’s, and 72(t) IRA’s in your inventory.
  2. Make sure that you include the basis of all of your traditional IRA accounts in your calculations. Assuming that you have basis in at least one account, you should be able to locate this on Form 8606 – Nondeductible IRAs that is part of the tax filing for the most recent year that you made a nondeductible contribution to a traditional IRA, received a distribution from a traditional IRA or Roth IRA, or did a Roth IRA conversion.
  3. For partial conversions of a single traditional IRA, include a pro rata portion of the basis of the account based on the value of the account being converted relative to the total value of the account.
  4. Where there are multiple accounts and you are either converting a portion of one account or 100% of one of two or more accounts, include a pro rata portion of the basis of all accounts based on the value being converted relative to the total value of all accounts.

Above all, always remember that if you’re not converting 100% of your traditional IRA’s to a Roth IRA, don’t use all of your basis!

Categories
Roth IRA

Not Converting 100% of Your Traditional IRA’s? – Don’t Use All of Your Basis – Part 1

Retirement Income Center

In the August 2, 2010 post, Remember Your IRA Basis Scorecard When Planning Roth IRA Conversions, the concept of basis, including the importance of tracking it and using it to offset otherwise taxable gains in connection with Roth IRA conversions, was discussed. This post and next week’s post are follow-ups to that post since they expand upon the discussion of how taxable gains are calculated in connection with a partial Roth IRA conversion when basis is available.

We learned in Remember Your IRA Basis Scorecard When Planning Roth IRA Conversions that you’re taxed on the difference between the value of your distribution and your basis in the distribution. This is a relatively simple calculation when you convert 100% of all of your traditional IRA accounts, however, it’s a different story when you do a partial Roth IRA conversion.

A partial Roth IRA conversion occurs when you convert less than the total value of all of your traditional IRA accounts to a Roth IRA. Partial Roth IRA conversions come in three flavors. They include conversions of:

  1. A portion of a single traditional IRA account,
  2. A portion of a traditional IRA account where there are multiple traditional IRA accounts, or
  3. 100% of one of two or more traditional IRA accounts

Scenario #1 is pretty straightforward when calculating taxable gains, however, scenario’s #2 and #3 can be problematic when basis is present if you’re not careful. The best way to illustrate is by using examples. Before doing so, however, it’s important to point out an often-overlooked issue when dealing with scenarios #2 and #3 which can contribute directly to the taxable gain calculation problem.

When considering one’s traditional IRA’s, always keep in mind that there are several types of accounts that fall under the traditional IRA umbrella. Basically, any IRA account that isn’t a Roth IRA, beneficiary IRA, or SIMPLE IRA account is generally a traditional IRA account. This includes regular, or contributory IRA accounts which can include both deductible and nondeductible IRA contributions, rollover IRA’s, SEP-IRA’s (see the June 21st post, Don’t Forget About Your SEP-IRA for Roth IRA Conversions), and 72(t) IRA’s (see the July 26th post, Considering a Partial 72(t) Roth IRA Conversion? – Tread Lightly).

Whenever you calculate the taxable gain in connection with a partial Roth IRA conversion, the first thing you should always do is take an inventory of your various IRA accounts to make sure that you include all of your traditional IRA accounts as well as the basis from each of your accounts in your calculation.

Next week’s post will illustrate each of the three partial Roth IRA conversion scenarios, including the calculation of taxable gain. Stay tuned.

Categories
Annuities Celebration Retirement Asset Planning Retirement Income Planning Roth IRA

Retirement Income Visions™ Celebrates 1-Year Anniversary!

Retirement Income Center

It’s hard to believe that a whole year has gone by since Retirement Income Visions™ initial blog post, but it has! This marks Retirement Income Visions™ 52nd post since it debuted on August 16, 2009 as a weekly blog, with new posts published each Monday morning.

As stated in the initial post, Retirement Income Visions™ Makes Its Debut, the blog, and the associated importance of retirement income planning as a separate and distinct niche, was inspired and motivated by my clients’ experience during the October, 2007 – March, 2009 stock market decline.

Also, as stated in the initial post, my goal in writing Retirement Income Visions™ was, and still is, to bring to your attention innovative planning strategies that you can use to create and optimize your retirement income, and, in many cases, reduce your exposure to adverse financial market conditions. If reader feedback, Twitter followers, and media attention, including a May 15th quote by The Wall Street Journal as the result of the timely publishing of the May 10th post, Be on the Lookout for Roth IRA Conversion Opportunities, is any indication, it appears that I’m off to a great start in achieving this goal.

I’ve covered a broad spectrum of information over the course of the last year, however, it’s been anything but random. If you’re a subscriber or regular reader, you’ve probably noticed the themed approach that’s been used to build upon, and provide a body of knowledge about, different retirement income planning topics. This has included the creation of a customized Glossary of Terms to assist in the understanding of the technical subject matter. The Glossary currently includes definitions of 84 terms.

Following the initial post, the next 11 posts addressed the retirement planning paradigm shift from retirement asset to retirement income planning, including associated risks associated with the former type of planning that has been the impetus for this shift.

The last 8 posts of 2009 focused on creating and optimizing retirement income via strategic systematic implementation of single premium immediate (“SPIA’s”) and deferred income (“DIA’s”) annuities. This series culminated in the December 28, 2009 interview of Curtis Cloke, the inventor of the Thrive® Income Distribution System, one of the leading retirement income planning solutions available to financial advisors.

2010 kicked off with the January 4th publishing of What Tools Does Your Financial Advisor Have In His or Her Toolbox? This post cited a 2009 Fidelity study that found that 83% of investors between the ages of 55 and 70 who are working with a fee-based adviser believe it’s more important for them to generate guaranteed (subject to individual insurers’ claims paying ability) income for retirement than to deliver above-average returns. The implied dilemma is that not all financial advisors have made the transition from using retirement asset to retirement income planning strategies for their clients.

Beginning with the January 11th post, Year of the Conversion, the last 30 posts have focused on a retirement income planning strategy that, although it has been around since 1998, was thrust into the limelight this year with the removal of its entrance barrier. I’m referring to the Roth IRA conversion technique that, up until 2010, was limited to taxpayers with modified adjusted gross income of less than $100,000.

While anyone who has a traditional IRA can convert part or all of his/her accounts to one or more Roth IRA accounts to embrace the two main attractions of a Roth IRA, i.e., nontaxable distributions and no required minimum distributions (“RMD’s”), this strategy isn’t necessarily beneficial for all traditional IRA owners. This is one area where multi-year income tax and retirement income planning analysis is essential for determining (1) who is a good candidate, (2) how much traditional IRA should be converted, and (3) when conversions should be made. In addition, there are various tricks and traps that need to be understood and incorporated in Roth IRA conversion planning in order to increase the probability for success.

I want to thank all of my readers for taking the time to read Retirement Income Visions™. A special thanks to my clients and non-clients, alike, who have given me great feedback regarding various blog posts. Last, but not least, thank you to my amazing wife, Nira, for all of her support with this endeavor. She has spent many a Saturday morning the last year doing other activities while I’ve been sitting at my desk writing this blog.

Categories
Financial Planning Roth IRA

Remember Your IRA Basis Scorecard When Planning Roth IRA Conversions

Retirement Income Center

Most people who sell assets are familiar with the income tax concept of “basis.” Basis, in its simplest form, is essentially what you pay for something. When you sell an asset, you’re not taxed on the sales proceeds. Instead, you pay tax on the difference between your net sales proceeds and your cost basis. Net sales proceeds is equal to gross sales proceeds reduced by any selling expenses. Cost basis is equal to purchase price plus increases to the purchase price less accumulated depreciation or amortization. Basis, therefore, reduces the amount of otherwise taxable gain.

The concept of “basis” also applies to traditional IRA’s. When you make a contribution to a traditional IRA, your contribution is either deductible, partially deductible, or nondeductible depending upon (1) whether you’re an active participant in a qualified retirement plan, (2) the amount of your modified adjusted gross income, and (3) your tax filing status. To the extent that any portion of your IRA contributions are deductible, they aren’t credited with any basis. Nondeductible IRA contributions, on the other hand, are counted as, and increase, traditional IRA basis.

So what’s so important about basis when it comes to traditional IRA’s? As stated above, basis reduces the amount of otherwise taxable gain. When might you have taxable gain with IRA’s? Unlike assets which can result in a taxable gain when you sell them, traditional IRA’s can result in taxable gains when you take distributions from them. As we’ve learned from previous blog posts, a Roth IRA conversion is, in essence, an IRA distribution.

Similar to assets whereby you’re taxed on the difference between your net sales proceeds and your cost basis, with traditional IRA’s, you’re taxed on the difference between the value of your distribution and your basis in the distribution. How do you know what your basis is in your IRA? Keeping in mind that IRA basis originates from nondeductible IRA contributions, you need a way to keep track of your nondeductible IRA contributions. IRS has provided us with this ability with Form 8606 – Nondeductible IRAs. Form 8606 is your scorecard for keeping track of your traditional IRA basis.

Form 8606 is required to be filed with your tax return in any year that you make nondeductible contributions to a traditional IRA. In addition to reporting the amount of your current year’s nondeductible traditional IRA contributions on line 1, you are required to report your total basis in traditional IRAs on line 2. Total basis in traditional IRA’s represents your cumulative nondeductible IRA contributions reduced by any previously used basis.

Since Form 8606 isn’t required to be filed every year, it’s easy to forget about basis when calculating the amount of taxable IRA distributions, especially if it’s been a while since you’ve made nondeductible contributions to your traditional IRA and you haven’t retained copies of all of your tax returns. This can be especially problematic if you haven’t used a professional income tax preparer to prepare your income tax returns in all of the years that you’ve made nondeductible traditional IRA contributions or if you’ve changed tax preparers over the years. Tracking IRA basis can be further complicated to the extent that the basis in your traditional IRA is different for federal vs. state income tax purposes as a result of state vs. federal deductible IRA calculation differences such as has been the case in California.

If you’re considering doing a Roth IRA conversion, don’t forget about Form 8606 – your traditional IRA basis scorecard. It will reduce the amount of your taxable Roth IRA conversions and, in turn, will reduce the amount of income tax you will otherwise pay.

Categories
Roth IRA

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

Retirement Income Center

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.)

Categories
Roth IRA

Got Dormant 401(k)? Consider Converting to a Roth IRA

Retirement Income Center

Last week’s blog post, Don’t Forget About Your SEP-IRA for Roth IRA Conversions, made the point that most people who are considering doing a Roth IRA conversion think about using a traditional IRA account into which deductible and/or nondeductible contributions have been made. Many people don’t realize that other types of retirement plans are also eligible for a Roth IRA conversion. One such plan is the popular 401(k).

Many employers allow former employees to keep their 401(k) plans intact, however, there’s an often-overlooked catch which I’ll get to shortly. As a result, 401(k) plans often lie dormant for years after an individual parts ways with his/her employer. In addition to limitation of investment choices, this can also result in an unpleasant surprise for a plan participant’s beneficiaries upon the plan participant’s death. This is due to the fact that employers that permit former employees to retain their 401(k) plans generally don’t allow them to do so indefinitely. Most plans require immediate distribution of plan assets at death, resulting in immediate taxation and the abrupt end of tax-deferred growth of the plan.

The lack of investment choices and the exposure to immediate taxation upon death are two great reasons, in my opinion, to move 401(k) plan assets into another tax-deferred vehicle as soon as possible following employment termination. Before 2008, besides a new employer’s 401(k) plan, the only choice available for rollover of 401(k) plan assets was a traditional IRA account. If you wanted to move your 401(k) plan assets into a Roth IRA, a two-step process was required whereby you first needed to roll 401(k) funds over to a traditional IRA account and then do a Roth IRA conversion of your traditional IRA.

As a result of a change made by the Pension Protection Act of 2006, beginning in 2008, funds from 401(k) plans can now be rolled directly to a Roth IRA via a Roth IRA conversion. Unlike 401(k) plans, with both Roth and traditional IRA’s, there are generally a myriad of investments from which you can choose, depending upon the financial institution you use as your custodian. Unlike traditional IRA’s where assets continue to grow tax-deferred until distributed, all pre-tax contributions and earnings are taxable upon conversion to a Roth IRA, with future earnings and growth accumulating tax-free inside the Roth IRA.

At a minimum, with limited exceptions which are beyond the scope of this blog post, most 401(k) plans should be rolled over to a traditional IRA upon separation from employment. Before doing this, however, a 401(k) plan participant should evaluate whether it makes more sense instead to do a Roth IRA conversion. As with all Roth IRA conversion decisions, there are many factors to consider. These include, but are not limited to, the size of the 401(k) plan, amount of pre-tax contributions and earnings, availability of losses and deductions to offset income from the conversion, current and projected income tax brackets, the plan participant’s age and general health, potential beneficiaries, and affect on taxation of Social Security benefits, Medicare premiums, and qualification for college financial aid.

Do you have a dormant 401(k)? If so, consider converting to a Roth IRA.

Categories
Roth IRA

Don’t Forget About Your SEP-IRA for Roth IRA Conversions

Retirement Income Center

On a recent occasion, I was discussing the Roth IRA conversion strategy with a long-time friend who told me that he converted his IRA to a Roth IRA years ago, and furthermore, he spread the income from the conversion over four years to reduce his tax bite. My friend was referring to the one-time opportunity to do a Roth IRA conversion in 1998 and spread the income from the conversion over four years starting with 1998 provided that your modified adjusted gross income was less than $100,000.

I knew that, in addition to his Roth IRA, my friend, who is an employee of his closely-held corporation, had another type of retirement plan. When I questioned him about this, he told me that he also has a SEP-IRA account into which he makes contributions every year. I asked him if he was aware that he could convert a portion, or all, of his SEP-IRA to a Roth IRA and he told me he didn’t know he could do this.

My friend is not alone. Some of you may have noticed in last week’s blog post, The 45 to 60 5-Year Roth IRA Conversion Strategy – Part 4 that a SEP-IRA was used in the hypothetical Roth IRA conversion strategy spreadsheet and may have wondered about the ability to use a SEP-IRA to do a Roth IRA conversion.

When you hear about doing a Roth IRA conversion, most people immediately think about using a traditional IRA account into which you made, or are still making, deductible and/or nondeductible contributions, the maximum contribution limits of which began at $1,500 in 1974, increased to $2,000 in 1981, $4,000 in 2005, and $5,000 in 2008, with an additional $1,000 for individuals 50 and over beginning in 2002. Traditional IRA’s can also include rollovers, or tax-free distributions, from another retirement plan, such as a 401(k) or 403(b) plan.

What isn’t so common, and is often lost in the Roth IRA conversion conversation, is the ability to use a SEP-IRA for the conversion. For those of you not familiar with SEP-IRA’s, this is a retirement plan used by self-employed individuals and small business owners. Sole proprietorships, Subchapter “S” and “C” corporations, partnerships, and LLC’s are all eligible to establish a SEP-IRA. Unlike traditional IRA’s which have relatively small contribution limits, currently $5,000 if under age 50 and $6,000 for individuals 50 and older, the maximum allowable contribution limit for SEP-IRA’s is much greater. Contributions of up to 25% of salary, or 20% of net adjusted self-employment income, up to $49,000, may be made to a SEP-IRA.

With this higher contribution limit, it isn’t unusual for SEP-IRA accounts to quickly grow to several hundred thousand dollars. Assuming similar starting dates, other than traditional IRA’s that contain sizeable rollovers from other retirement plans, the value of most SEP-IRA accounts typically dwarf those of traditional IRA’s. Given this situation, partial, rather than full, conversions of SEP-IRA’s generally will achieve the goal of minimizing income tax liability attributable to the conversion. Furthermore, assuming that ongoing contributions are still being made to the plan, a multi-year conversion strategy such as the hypothetical Roth IRA conversion strategy illustrated in last week’s blog post, The 45 to 60 5-Step Roth IRA Conversion Strategy – Part 4 can make a lot of sense.

If you have a SEP-IRA account, I would strongly urge you to explore the possibility of converting a portion, or all, of the current balance, as well as future contributions, to a Roth IRA, using a multi-year strategy such as the one illustrated in the four-part series, The 45 to 60 5-Setp Roth IRA Conversion Strategy.

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Roth IRA

The 45 to 60 5-Step Roth IRA Conversion Strategy – Part 4

Retirement Income Center

Part 1 of this blog post introduced a 5-step Roth IRA conversion strategy for individuals 45 to 60 years old who either own a sizeable traditional IRA or have the opportunity to roll over a sizeable 401(k) plan or other retirement plan to an IRA. Steps 1 and 2 of this strategy was presented two weeks ago in Part 2 and steps 3 and 4 were discussed last week in Part 3.

This week’s post presents the fifth and final step together with a hypothetical case to illustrate the use of this strategy. If you haven’t done so already, I would recommend reading Parts 2 and 3 to learn about steps 1, 2, 3, and 4.

Step 5 – Complete Your Conversion Plan No Later Than the Year Before You Turn 70-1/2

As discussed in the January 11, 2010 blog post, Year of the Conversion, there are two main benefits of a Roth IRA that aren’t available to traditional IRA owners:

  1. Nontaxable distributions
  2. No required minimum distributions (“RMD’s”)

No one I know likes to be forced to do anything. In order to realize benefit #2, it’s important to target your conversion plan completion date for no later than the year before you turn 70-1/2. Once you reach this milestone, you will be required to take minimum distributions from your traditional IRA accounts each year based on your traditional IRA account value on December 31st of the preceding year and an IRS table life expectancy factor. Assuming that you complete your Roth IRA conversion plan by the year before you turn 70-1/2, you won’t be subject to the “RMD” rules.

Hypothetical Case

Now that we have completed our discussion of the 5-step Roth IRA conversion strategy, let’s take a look at a hypothetical case. Keeping in mind that you want to (a) have your 2010 conversion amount be larger than in subsequent years, (b) skip 2011 and 2012 if you deferred the taxation of your 2010 Roth IRA conversion income, (c) convert equal amounts thereafter, and (d) complete your conversion plan no later than the year before you turn 70-1/2, let’s make the following ten assumptions:

  1. Individual age 50 in 2010
  2. Sufficient liquid nonretirement assets to pay income taxes attributable to annual conversions
  3. SEP-IRA with beginning of 2010 value of $400,000 and cost basis of $0
  4. Earnings of 5%
  5. Annual SEP-IRA contributions of $20,000 through age 65
  6. 2010 Roth IRA conversion of $160,000
  7. Taxation of 2010 Roth IRA conversion deferred to 2011 and 2012
  8. No 2011 and 2012 Roth IRA conversions
  9. 2013 and subsequent year conversions of $45,000
  10. Final conversion at age 69 after which SEP-IRA account value = $0

Per the Hypothetical Roth IRA Conversion Strategy spreadsheet, the 2010 value of $400,000, total earnings of approximately $196,000, and total SEP-IRA contributions of $320,000 results in Roth IRA conversions totaling approximately $916,000 by age 69. Not only will the Roth IRA conversions of $916,000 not be subject to additional taxation, 100% of the growth of the Roth IRA funds will escape income taxation provided that the funds remain in the Roth IRA for at least five years from the beginning of the year of each conversion and until age 59-1/2.

It’s important to keep in mind that this is a hypothetical case and actual conversion amounts in a particular situation, assuming a Roth IRA conversion makes sense, will depend on many factors that need to be carefully analyzed for each conversion year.

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IRA Roth IRA

The 45 to 60 5-Step Roth IRA Conversion Strategy – Part 3

Retirement Income Center

Part 1 of this blog post introduced a 5-step Roth IRA conversion strategy for individuals 45 to 60 years old who either own a sizeable traditional IRA or have the opportunity to roll over a sizeable 401(k) plan or other retirement plan to an IRA. Last week’s post presented steps 1 and 2 of this strategy. This week’s post discusses steps 3 and 4. Step 5 will be presented in Part 4 together with a hypothetical case to illustrate the use of this strategy. If you haven’t done so already, I would recommend reading Part 2 to learn about steps 1 and 2.

Step 3 – Convert An Equal Amount Each Year Beginning in the Year After the Year(s) in Which You Recognize Your 2010 Conversion Income

If you deferred the taxation of your 2010 Roth IRA conversion income, you should plan on converting an equal amount of your traditional IRA to a Roth IRA each year from 2013 until you complete your Roth IRA conversion strategy in order to keep things simple and increase the likelihood of sticking with your plan. Alternatively, if you recognized your 2010 Roth IRA conversion income on your 2010 income tax returns, you should begin your “equalization” phase in 2011.

Depending upon income tax rates and your particular situation, there may be years when you will want to increase or decrease your conversion amount in order to minimize your income tax liability. To the extent that you do this, you will need to adjust your annual equalization amount going forward. You will also need to adjust your future annual equalization amounts for any additional contributions or rollovers to your traditional IRA as well as for any recharacterizations (See Recharacterization – Your Roth IRA Conversion Insurance Policy).

Step 4 – Complete Your Conversion Plan by Your Social Security Benefit Commencement Date If It Makes Sense

As a general rule, if possible, you should plan on completing your Roth IRA conversions by the date when you will begin receiving Social Security benefits. This will be much easier to accomplish if you begin your conversion plan between age 45 and 50 assuming that your traditional IRA is not increased by any sizeable contributions and/or rollovers after age 50.

Given the overriding goal of reducing the taxation of Social Security benefits and the fact that Social Security benefit taxation is directly influenced by the amount of your other taxable income, the absence of Roth IRA conversion income could reduce, or potentially eliminate, otherwise taxable Social Security benefits under current income tax laws.

Assuming your other income is projected to be sufficient to cover your expenses, it may even be advisable to defer your Social Security benefit commencement date so that you may extend your conversion period and, in turn, minimize your Roth IRA conversion income tax liability.

In addition, since the Medicare Part B, or medical insurance, premium amount is determined by one’s income, the absence of Roth IRA conversion income beginning at age 65 could help keep Medicare Part B premiums in check.

Depending upon your current age, it may not be prudent to complete your Roth IRA conversions by your Social Security benefit commencement date since doing so may require you to incur a substantial amount of income tax liability in connection with your Roth IRA conversion amounts. This is especially true if you’re 60 or older when you begin your conversion plan, you have a sizeable traditional IRA, and you aren’t planning on doing any conversions in 2011 and 2012 (see Step 2 in Part 2). In addition, if it is projected that you will have a substantial amount of income from other sources that is projected to result in taxation of your Social Security benefits, it probably won’t make sense in most cases to accelerate your Roth IRA conversion plan so that it is completed by your Social Security benefit commencement date.

For the fifth and final step of the 45 to 60 Roth IRA conversion strategy, watch for Part 4 next week.

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Roth IRA

The 45 to 60 5-Step Roth IRA Conversion Strategy – Part 2

Retirement Income Center

Part 1 of this blog post introduced a 5-step Roth IRA conversion strategy for individuals 45 to 60 years old who either own a sizeable traditional IRA or have the opportunity to roll over a sizeable 401(k) plan or other retirement plan to an IRA. This post presents steps 1 and 2 of this strategy, with steps 3 and 4 to be discussed in Part 3, and step 5 to be presented in Part 4 together with a hypothetical case to illustrate the use of this strategy.

Step 1 – Begin Your Plan in 2010 Using a Larger Conversion Amount Than in Subsequent Years

I’m recommending that you begin your Roth IRA conversion strategy in 2010 to take advantage of the one-time opportunity to defer 50% of the income from your 2010 conversion to 2011 and 50% to 2012 or, alternatively, take advantage of lower income tax rates in 2010 if you elect to include the income from your 2010 conversion on your 2010 federal income tax return if this makes more sense for you (see In Which Tax Year(s) Should You include Your 2010 Roth IRA Conversion Income – Parts 1, 2, and 3).

Given this unique tax planning opportunity, it will make sense in most cases to convert a larger portion of your traditional IRA to a Roth IRA in 2010 than in future years. I generally recommend to my clients a 2010 conversion amount of approximately 2-1/2 to 4 times the size of the annual subsequent year conversion amounts per Step 3 (See Part 3 next week), depending upon their current IRA value, the cost basis of their IRA, future planned IRA contribution amounts, and the total number of years over which conversions will be made.

Furthermore, if you will be doing a larger Roth IRA conversion in 2010, per my blog post two weeks ago (Be on the Lookout for Roth IRA Conversion Opportunities), it’s prudent to execute your conversion(s) following market declines whenever possible in order to convert the largest amount of your traditional IRA with the least amount of income tax liability.

Step 2 – Skip 2011 and 2012 If You Deferred the Taxation of Your 2010 Roth IRA Conversion Income

Assuming that you converted, or will convert, a sizeable portion of your traditional IRA to a Roth IRA in 2010 and will defer the taxation of your 2010 conversion to 2011 and 2012, with some exceptions, it probably won’t make sense in most situations to do any additional Roth IRA conversions in 2011 and 2012. Unless you have some significant tax sheltering opportunity, e.g., sale of rental property resulting in a large passive activity loss with minimal capital gains, net operating loss, large charitable contribution deduction from establishment and funding of a charitable remainder trust, etc., you should plan on skipping 2011 and 2012 Roth IRA conversions in order to avoid adding yet another layer of income onto your already bloated 2011 and 2012 taxable income.

So you know what to do for the next three years. What’s the plan after 2012? Stay tuned for Steps 3 and 4 in Part 3 next week.

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Roth IRA

The 45 to 60 5-Step Roth IRA Conversion Strategy – Part 1

Retirement Income Center

Are you 45 to 60 years old and either have a sizeable traditional IRA or have the opportunity to roll over a sizeable 401(k) plan or other retirement plan to an IRA? If so and you would like to enhance the likelihood of maximizing your retirement benefits, you should consider implementing a multi-year systematic plan to convert the vast majority, if not all, of your traditional IRA to a Roth IRA.

Ideally, you want to begin converting your traditional IRA to a Roth IRA beginning in 2010 and complete your conversion plan by the year that you will begin receiving Social Security benefits or no later than the year before you will turn 70-1/2. Your age, the value of your IRA, future contributions to your IRA, recharacterizations (See Recharacterization – Your Roth IRA Conversion Insurance Policy), income tax rates, income tax planning opportunities, and source of funds to pay the income tax liability attributable to your conversions will directly affect your actual annual conversion amounts as well as when you will complete your plan.

The last factor – source of funds to pay the income tax liability attributable to your conversions – needs to be carefully analyzed before you do a one-time conversion, let alone design a multi-year Roth IRA conversion plan. Per the January 25, 2010 post, Three Roth IRA Conversion “Show Stoppers,” if you don’t have sufficient funds in checking, savings, money market, and other nonretirement accounts outside of your IRA to pay the tax attributable to a Roth IRA conversion, you aren’t a good candidate for a Roth IRA conversion. The importance of this liquidity analysis is magnified in a multi-year plan.

Assuming that liquidity isn’t projected to be an issue and assuming there aren’t any other factors present that would negate the potential benefits to be derived from one or more Roth IRA conversions, there are five steps that should be included in a Roth IRA conversion plan for individuals who are 45 to 60 years old as follows:

  1. Begin your plan in 2010 using a larger planned conversion amount than in subsequent years.
  2. Skip 2011 and 2012 if you deferred the taxation of your 2010 Roth IRA conversion income.
  3. Convert an equal amount each year beginning in the year after the year(s) in which you recognize your 2010 conversion income.
  4. Complete your conversion plan by your Social Security benefit commencement date if it makes sense.
  5. Complete your conversion plan no later than the year before you turn 70-1/2.

Steps 1 and 2 will be addressed in Part 2 of this blog post, steps 3 and 4 will be discussed in Part 3, and step 5 will be presented in Part 4 together with a hypothetical case to illustrate the use of this strategy.

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Roth IRA

Be on the Lookout for Roth IRA Conversion Opportunities

Retirement Income Center

Was last week’s 5.7% decline in the Dow Jones Industrial Average (DJIA), from 11,009 on April 30th to 10,380 on May 7th, a temporary pullback from the recent highs this year or the beginning of a prolonged market decline? Unless your crystal ball works better than mine, we won’t know the answer to this question until several months or more from now when we’re looking in the rearview mirror.

While I don’t practice market timing for my clients, I believe that it’s prudent to look for opportunities to implement investment strategies to take advantage of various market conditions. Although a Roth IRA conversion will result in elimination of income tax liability on Roth IRA distributions provided no withdrawals are taken within five years of the conversion and the Roth IRA owner is at least 59-1/2 when taking distributions (see Year of the Conversion), this benefit can be negated by income tax liability associated with the conversion, itself.

When exploring a Roth IRA conversion, you want to look for opportunities to convert the greatest amount of your traditional IRA to a Roth IRA with the least amount of income tax liability. There are three things that directly affect the amount of income tax liability you will incur in connection with a Roth IRA conversion as follows:

  1. Income tax attributes
  2. Income tax rates, allowable deductions, and tax credits
  3. Investment valuation

Income tax attributes were addressed in the following three blog posts:

  1. The Ideal Roth IRA Conversion Candidate – Part 1
  2. The Ideal Roth IRA Conversion Candidate – Part 2
  3. Two Great Roth IRA Conversion Candidates

Although it can turn out otherwise, there is general consensus that the income tax rates, allowable deductions, and tax credits in effect in 2010 will probably be as good as it gets for a long time. With the scheduled 2011 3% – 5% income tax bracket increases (see In Which Tax Year(s) Should You Include Your 2010 Roth IRA Conversion Income? – Parts 1 and 2), it could be beneficial to make an election to report 100% of your Roth IRA conversion income on your 2010 income tax return vs. deferring and splitting the income between 2011 and 2012.

This leaves investment valuation. While we’re general unable to influence and control market prices, we’re able to choose when and how we want to participate in the market. Even though a Roth IRA conversion is generally a long-term strategy, if possible, you want to execute your conversions after market declines. To the extent that you’re considering a Roth IRA conversion, a 5+% market decline such as the one we recently experienced, combined with the fact that the DJIA is down 26.7% from its October 9, 2007 high of 14,165, may be an opportunity to do a partial or complete Roth IRA conversion.

Be on the lookout for market declines and associated Roth IRA conversion opportunities. As discussed in Roth IRA Conversion – A Multi-Year Strategy, a Roth IRA conversion doesn’t have to be, and in most cases shouldn’t be, a one-time event. Multiple opportunities may play out within one year or potentially over several years. If you’re wearing your Roth IRA conversion binoculars, you’ll spot them. If it turns out that the market declines further from the time of your conversion and you’re within the permissible timeframe, don’t forget about another investment strategy – recharacterization (see Recharacterization – Your Roth IRA Conversion Insurance Policy).