Tag: traditional IRA

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Roth IRA

In Which Tax Year(s) Should You Include Your 2010 Roth IRA Conversion Income? – Part 1

Retirement Income Center

If you’ve read any of the last 15 blog posts, you understand that the decision to convert a traditional IRA to a Roth IRA isn’t typically a slam dunk. There are some instances when you should never do a Roth IRA conversion (see Three Roth IRA Conversion “Show Stoppers”). When a Roth IRA conversion is appropriate, in most cases it makes sense to convert a portion of a traditional IRA to a Roth IRA over several years rather than 100% in one year (see Roth IRA Conversion – A Multi-Year Strategy).

2010 is a unique year for Roth IRA conversions. In addition to the removal of the $100,000 modified adjusted gross income Roth IRA conversion eligibility threshold (see Year of the Conversion), if you do a conversion in 2010, the income from your conversion won’t be reported in 2010. Instead, one-half of the income will be included in 2011 and the other half will be included in 2012. You will need to make an election on your 2010 income tax return if you would like to report the income in 2010.

At first blush, the default of spreading your conversion income over two future years seems like a great opportunity since (a) you’re not recognizing any income from your conversion on your 2010 federal income tax return, (b) you’re deferring income to a future year, with 50% deferred for two years, and (c) depending upon the amount of your conversion, by splitting your income, you may be able to reduce the top marginal tax bracket at which your Roth IRA conversion income will be taxed in 2011 and 2012.

Unfortunately, the decision regarding when to recognize your Roth IRA conversion income is complicated by the fact that, in the absence of Congressional action, our current relatively low tax brackets will be replaced by the pre-2001 tax brackets which are generally higher. Assuming that Congress takes no action, 2010 income tax brackets will increase by at least 3% for most levels of income as follows:

2010 Tax Bracket

2011 Tax Bracket

10%

15%

15%

15%

25%

28%

28%

31%

33%

36%

35%

39.6%

While there will be no increase in the 15% tax bracket and the increase will be 3% for the 25%, 28%, and 33% tax brackets, the increases are more severe for the 10% and 35% brackets. The 10% bracket will increase by 5% to 15% and the 35% bracket will increase by 4.6% to 39.6%. It’s important to keep in mind that the tax brackets being illustrated are marginal tax brackets. As an example, if you’re currently in the 33% tax bracket, you are affected by the changes in all of the brackets below 33% as well as the 33% tax bracket, since different layers of your income are taxed at 10%, 15%, 25%, 28%, and 33%, respectively, to calculate your 2010 tax liability.

As if it isn’t difficult enough deciding whether or not you should do a Roth IRA conversion this year and how much of your traditional IRA you should convert to a Roth IRA, you must also decide in which tax year(s) you should include the income from your conversion. Part 2 will show the different levels of income associated with the above 2010 and projected 2011 tax brackets. Part 3 will use an example to compare the use of the 2010 Roth IRA conversion income deferral default to the optional 2010 inclusion.

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IRA Roth IRA

Recharacterization – Your Roth IRA Conversion Insurance Policy

Retirement Income Center

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.

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IRA Roth IRA

Roth IRA Conversion – A Multi-Year Strategy

Retirement Income Center

With all of the buzz about Roth IRA conversions this year as a result of the elimination of the $100,000 modified adjusted gross income threshold for converting traditional IRA’s to Roth IRA’s, clients and non-clients alike have been asking me the million-dollar question, “Should I do a Roth IRA conversion?” The underlying implied question usually is, “Should I convert 100% of my traditional IRA to a Roth IRA this year?”

Despite the media frenzy and the associated rush to do Roth IRA conversions in 2010 to obtain the alleged benefit of recognition of 50% of the income from the conversion in 2011 and 50% in 2012, a Roth IRA conversion, if it makes sense, doesn’t have to be, and in most cases shouldn’t be, a one-time event. Unless you meet the criteria of one or more of the four ideal candidates presented in The Ideal Roth IRA Conversion Candidate – Parts 1 and 2, you should be using a multi-year strategy for your Roth IRA conversions. Even if you’re an “ideal candidate,” it still may make sense to defer a portion of your conversion to 2011 and later years.

One of my clients, Mr. and Mrs. Retired, meet the criteria of Ideal Candidate #1 presented in the February 8th blog, The Ideal Roth IRA Conversion Candidate – Part 1, i.e., no current income tax liability without any tax losses. Mr. and Mrs. R. are both less than 70-1/2, are taking distributions from nonretirement accounts, a large portion of which are nontaxable or tax-favored, and their itemized deductions and personal exemptions offset whatever otherwise taxable income they have so that they aren’t subject to any income tax liability. Mr. R. retired at the end of 2006.

A substantial portion of Mr. and Mrs. R.’s investment assets are in retirement accounts, including traditional IRA’s and Roth IRA’s that have been converted from traditional IRA’s over the last three years since Mr. R. retired. Even though their tax situation is such that they aren’t incurring any income tax liability, it didn’t make sense to convert 100% of Mr. and Mrs. R’s traditional IRA’s to Roth IRA’s in 2007, the year after Mr. R. retired, nor did it make sense to do this over three years since Mr. and Mrs. R. would incur income tax liability they would otherwise not incur.

The strategy that I’m using with Mr. and Mrs. R. has been to prepare one or more income tax projections each year to determine the optimal amount of traditional IRA’s that can be converted to Roth IRA’s without incurring any income tax liability. This is tricky since the conversion amount is limited by the inclusion of a portion of Mr. R.’s Social Security benefits in income that wouldn’t otherwise be includible without the conversion. This strategy has resulted in the successful conversions of $30,000 to $60,000 a year, or a total of $140,000 over the last three years, without any associated income tax liability. We will continue to employ this strategy over the next several years to convert the remainder of Mr. and Mrs. R.’s traditional IRA’s to Roth IRA’s without recognizing any income tax liability.

The next time you ask your financial advisor, “Should I do a Roth IRA conversion?,” you might want to add to the end of the question, “…this year or over the next several years?”

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IRA Roth IRA

Consequences of Not Doing Your RMD Before Your RIC

Retirement Income Center

The lesson of last week’s blog post is that if you’re 70-1/2+, IRS deems the first distributions from your traditional IRA to satisfy your required minimum distribution(“RMD”) and therefore you must always take your RMD before doing a Roth IRA conversion. What are the consequences of not taking your RMD before doing your Roth IRA conversion? This post will answer this question and will discuss how to correct this situation.

At first blush, there would appear to be two potentially serious repercussions:

  1. 50% penalty on the amount that should have been withdrawn but was not, and
  2. 6% excise penalty for every year the money remains in your Roth IRA

Answer 6(c) of IRS Regulation 1.408A-4 (Converting amounts to Roth IRAs) enables you to potentially avoid both penalties by treating this situation as two distinct and separate events:

  1. A required minimum distribution, and
  2. Regular contribution to a Roth IRA vs. a Roth IRA conversion

If you do a Roth IRA conversion without first taking your RMD, IRS deems the portion of the conversion amount that is equal to your RMD amount to satisfy the RMD rules for that year and thus avoid a potential 50% penalty. This assumes that the conversion amount is at least equal to the amount of your RMD. The portion of your conversion amount that is less than your RMD would still be subject to the 50% penalty.

Assuming that your conversion amount is equal to or greater than your RMD amount, you’re out of the woods as far as your potential exposure to the 50% penalty. What about the 6% excise penalty? There are different rules for eligibility for a regular contribution to a Roth IRA vs. a Roth IRA conversion. Since your RMD amount is now treated as a regular contribution to a Roth IRA, your avoidance of the 6% excise penalty depends upon whether or not you are eligible to make a regular contribution to a Roth IRA as well as your RMD amount.

Eligibility for regular contributions to Roth IRA’s is dependent upon having earned income equal to at least the amount of the contribution and is also dependent upon the amount of one’s modified adjusted gross income (“MAGI”) which differs by filing status, the details of which are beyond the scope of this blog post. Even if you meet the eligibility requirements, the maximum amount of your Roth IRA contribution is limited to $6,000 if you’re age 50 or older.

If you don’t meet the eligibility rules for making a regular contribution to a Roth IRA, the portion of your Roth IRA conversion that is deemed to be an RMD will be subject to the 6% excise penalty. Furthermore, even if you satisfy the Roth IRA regular contribution rules, to the extent that the RMD portion of your Roth IRA conversion exceeds $6,000, it will be subject to the 6% excise penalty until it is corrected.

If you are either ineligible to make a regular contribution to a Roth IRA or, if you are eligible and the RMD portion of your Roth IRA conversion exceeds $6,000, how do you correct this situation and avoid the 6% excise penalty? In order to avoid the penalty, you must transfer the portion of the conversion that is deemed to be an RMD that doesn’t meet the Roth IRA regular contribution eligibility requirements plus earnings thereon back to your traditional IRA by the due date, including extension, for filing your tax return for the year of conversion.

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IRA Roth IRA

Do Your RMD Before Your RIC

Retirement Income Center

I’m not a big fan of acronyms because there’s way too many of them and it’s easy to get confused by them, however, my original title for this post, “Don’t Forget to Take Your Required Minimum Distribution (“RMD”) Before You Do Your Roth IRA Conversion (“RIC”)” was way too long. So, for my fellow non-acronym fans (otherwise known as “NAF’s”), please bear with me on this one.

With the one-year suspension of required minimum distributions (“RMD’s”) in 2009, it’s easy to forget that if you’re at least 70-1/2 years old, you must start, or resume, taking mandatory minimum withdrawals from your traditional IRA accounts in 2010 based on their account value on December 31, 2009 and an IRS life expectancy factor. The RMD rules are even further off the radar screen for those individuals age 70-1/2+ with modified adjusted gross incomes in excess of $100,000 who were previously ineligible for a Roth IRA conversion who were anxiously waiting for 2010 to roll around so that they could finally do a conversion.

If you’re 70-1/2, before you rush out and convert a portion, or all, of your traditional IRA to a Roth IRA, you must first take your RMD. Why is this? If you own a traditional IRA at any time during the year and you’re at least 70-1/2 years old, IRS says that the first distribution from your IRA always includes your RMD amount. Furthermore, RMD’s aren’t eligible to be rolled over to other IRA’s, including conversion to a Roth IRA.

Consequently, even though your RMD and your Roth IRA conversion are both taxed exactly the same way as ordinary income, you must always first take your RMD before converting any portion of your traditional IRA to a Roth IRA. What are the consequences of not taking your RMD before doing a Roth IRA conversion and is there a way to correct this? For the answer to these questions, you’ll need to wait for next week’s blog post.

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IRA Roth IRA

Reduce or Eliminate Your Required Minimum Distributions With a Roth IRA Conversion

Retirement Income Center

A lot of people I talk to get upset when they discover that they must begin taking required minimum distributions (“RMD’s”) from their traditional IRA’s beginning at age 70-1/2. They forget about all of the income tax savings that they’ve realized over the years from either making deductible IRA contributions or from making pre-tax contributions into 401(k) plans that they rolled over into their IRA accounts. This is especially true when they haven’t reinvested the tax savings from their deductible contributions which is fairly typical.

Moreover, many people don’t realize that IRS has authorized a deduction for their contributions in exchange for the right to tax distributions from their traditional IRA’s, whether voluntarily or via RMD’s. Whether or not you’ve taken any distributions from your IRA, beginning at age 70-1/2, you are required to take a minimum distribution each year from your traditional IRA accounts based on their value on December 31st of the preceding year and an IRS table life expectancy factor. The taxable portion of each distribution includes deductible contributions as well as earnings.

One way to “beat the system” and reduce, or potentially eliminate, your RMD’s is to do one or more Roth IRA conversions. Depending upon the amount of your Roth IRA conversion and your overall tax situation in a particular year, you may or may not incur tax liability in connection with your Roth IRA conversion. See The Ideal Roth IRA Conversion Candidate – Parts 1 and 2 and Two Great Roth IRA Conversion Candidates for strategies for reducing or potentially eliminating income tax liability in connection with a Roth IRA conversion. Whether or not you incur income tax liability, you will reduce your RMD amounts and eliminate them if you convert 100% of your IRA to a Roth IRA.

It’s important to keep in mind that by reducing or eliminating future RMD’s, you are doing so not only based on the current value of your IRA, you are also eliminating RMD’s attributable to future earnings. Furthermore, if you have children who will eventually inherit your IRA’s, you are reducing or eliminating their RMD’s as well.

To illustrate the potential power of elimination of RMD’s, I have prepared two spreadsheets as follows:

  1. Projected IRA Balances with Required Minimum Distributions (IRA #1)
  2. Projected IRA Balances Without Required Minimum Distributions (IRA #2)

The spreadsheets were prepared using the following assumptions:

  • Traditional IRA balance of $100,000 at age 50
  • Maximum annual contributions to traditional IRA’s from age 50 through age 69 on January 1st of each year
  • Maximum allowable contributions of $6,000 increased by $500 per year every five years
  • Earnings at 5%
  • Withdrawals of required minimum distributions only on January 1st of each year beginning at age 70 through age 85 in IRA #1

Per IRA #1, after withdrawing RMD’s totaling approximately $404,000 over 16 years, the IRA is projected to be worth approximately $478,000 at age 85. Per IRA #2, with no RMD’s, the value of the same account is projected to grow to approximately $1.079 million at age 85. Depending upon the amount of income tax liability attributable to IRA #1’s RMD’s and what the IRA owner does with the after-tax distributions, i.e., spends or reinvests, would allow a more thorough comparison of IRA #1 to IRA #2. In addition, it must be kept in mind that in order to eliminate RMD’s, the owner of IRA #2 would need to do a Roth IRA conversion at age 69, and, in the process, increase taxable income in that year by approximately $494,000.

A Roth IRA conversion can provide you with an opportunity to reduce or eliminate your RMD obligation as well as that of your children if they will inherit your IRA’s. Before doing any conversion, however, a detailed analysis should be prepared to determine if the projected benefits to be derived from a conversion, including the reduction or elimination of RMD’s, is worth the cost, i.e., the tax liability attributable to the conversion.

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IRA Roth IRA

Two Steps to a Nontaxable IRA for High Income Individuals

Retirement Income Center

If your goal is to contribute on a regular basis to a nontaxable investment account without investing in low-yielding tax-free municipal bonds from which you can take nontaxable distributions beginning at age 59-1/2 and assuming you can live with the annual contribution limits, IRS has provided you with this opportunity. Depending on the amount of your income each year, you will be able to achieve your goal in either one or two steps.

In 2010, if your modified adjusted gross income (“MAGI“) is less than $105,000 if you’re single or $167,000 if you’re married filing a joint return, you can contribute up to $5,000, or $6,000 if you’re 50 and over, to a Roth IRA assuming that you receive taxable compensation of at least these amounts. Your Roth IRA distributions will be nontaxable provided that you (a) don’t take any distributions for at least five years after you make your first Roth IRA contribution and (b) wait until you reach age 59-1/2 to take your distributions.

What if your MAGI exceeds the above thresholds and you’re therefore not eligible to make Roth IRA contributions, how do you achieve the goal stated at the outset of this blog? It can be done, however, you will need to do it in two steps as follows:

  1. Make nondeductible IRA contributions.
  2. Convert nondeductible IRA contributions to a Roth IRA.

Step 1: Make Nondeductible IRA Contributions

Assuming that your MAGI exceeds the stated thresholds for making Roth IRA contributions, you can make deductible contributions to a traditional IRA assuming that you aren’t an active participant in an employer-sponsored retirement plan. If you do this, however, 100% of the withdrawals from your IRA will be taxable. If, on the other hand, you’re an active participant in an employer-sponsored retirement plan, you can make non-deductible IRA contributions up to $5,000 or $6,000 if you’re 50 and over to a traditional IRA assuming that you receive taxable compensation of at least these amounts.

When it comes time to taking distributions, the good news is that the portion of your distributions representing contributions to your IRA will be nontaxable. If you leave your nondeductible contributions in a traditional IRA, you will not achieve your goal of nontaxable distributions, however, since the portion of your distributions representing earnings will be taxable as ordinary income. This could be substantial assuming you consistently make nondeductible maximum-allowable contributions over many years.

Step 2: Convert Nondeductible IRA Contributions to a Roth IRA

There is a second step that you need to follow religiously each year after making your nondeductible IRA contributions if you want 100% of your IRA distributions to be nontaxable. Immediately after making your nondeductible contributions to your traditional IRA account, you need to convert 100% of your contributions to a Roth IRA. Once your traditional IRA funds are transferred to your Roth IRA, none of the distributions from your Roth IRA will be taxable, including earnings, provided that you don’t take any distributions for at least five years after you make your first Roth IRA contribution and you wait until you reach age 59-1/2 to take your distributions.

Example

As an example of the potential power of using this strategy over an extended period of time, including illustrating the differences in taxation between deductible traditional IRA’s, nondeductible traditional IRA’s, and Roth IRA’s converted from traditional nondeductible IRA’s, please see Projected IRA and Taxable IRA Amounts spreadsheet. The spreadsheet was prepared using the following assumptions:

  • Maximum annual contributions to nondeductible traditional IRA’s from age 40 through age 69 on January 1st of each year
  • Immediate conversion of nondeductible contributions to Roth IRA
  • Maximum allowable annual contributions beginning at $5,000 increased by $500 per year every five years with additional $1,000 per year “catch-up” contributions beginning at age 50
  • Earnings at 5%
  • No withdrawals before age 70

Given the foregoing assumptions, per the spreadsheet, the projected value of the Roth IRA at age 60 would be $446,773, none of which would be taxable. Assuming that the nondeductible IRA contributions remain in a traditional IRA and aren’t converted to a Roth IRA, 100% of the projected earnings of $239,273 would be taxable. Finally, with a traditional deductible IRA, 100% of the projected contributions and earnings of $207,500 and $239,273, respectively, for a total of $446,773 would be taxable.

As you can see, it’s possible to accumulate a sizeable nontaxable nest egg if you start early and commit to making regular annual contributions. As an added bonus, because your funds are sitting in a Roth IRA, in addition to your withdrawals being nontaxable, they’re also not subject to the required minimum distribution rules.

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IRA Roth IRA

Two Great Roth IRA Conversion Candidates

Retirement Income Center

In the two previous blog posts, I examined four scenarios where it’s possible to convert a portion, and possibly all, of a traditional IRA to a Roth IRA while incurring minimal or no income tax liability attributable to the conversion, and, as such, qualify as ideal Roth IRA conversion candidates.

This week’s blog presents two additional Roth IRA conversion candidates that I would classify as “great,” but not “ideal,” candidates. Both scenarios have the potential for the IRA owner or beneficiaries to end up with more assets than they would if they don’t do a conversion, however, there could be a sizeable amount of income tax liability attributable to the conversion, depending upon the situation. The two scenarios are as follows:

  1. Substantial basis in IRA
  2. Surviving spouse in low tax bracket not dependent on IRA with children in high tax bracket

Substantial Basis in IRA

Whether or not you’re considering a Roth IRA conversion, if you’re an IRA owner, it’s important to know the amount of your basis in your IRA. What does this mean? If the origin of your IRA is entirely from deductible IRA contributions or other deductible retirement plan contributions assuming your IRA was rolled over from a qualified retirement plan, such as a 401(k) plan, then your basis is $0. When you either take distributions from your IRA or do a Roth IRA conversion, 100% of your distributions or conversion amount will be taxable.

On the other hand, suppose that part or all of your IRA came from either nondeductible IRA contributions or after-tax contributions from a qualified retirement plan that was rolled over to your IRA. In this case, distributions from your IRA or Roth IRA conversions that are attributable to your nondeductible IRA contributions or qualified retirement plan after-tax contributions will be nontaxable. All prior year, as well as current year, nondeductible and after-tax contributions are required to be reported to IRS on Form 8606 – Nondeductible IRAs.

As an example, I had a client recently approach me about converting his wife and his IRA accounts to Roth IRA accounts. The combined value of their IRA accounts is $98,000 with a basis arising from nondeductible IRA contributions totaling $67,000. Assuming they convert 100% of their respective IRA accounts to Roth IRA accounts, they would recognize ordinary income equal to the difference between the account values of $98,000 and their basis of $67,000, or $31,000. This is less than one-third of the total value of their IRA accounts.

Even though my clients are in a combined 45% federal and state marginal income tax bracket, resulting in income tax liability of approximately $14,000 attributable to a Roth IRA conversion, this is only 14% of the total combined value of their IRA accounts of $98,000. Taking into consideration the fact that my clients are in their early 40’s, they may never need to take distributions from their IRA accounts, they have nonretirement funds from which to pay the tax attributable to the conversion, and the stock market is currently priced well below its highs of a couple of years ago, I encouraged them to pursue a conversion of 100% of their respective traditional IRA accounts to Roth IRA accounts.

Surviving Spouse in Low Tax Bracket Not Dependent on IRA With Children in High Tax Bracket

The second great candidate for conversion of a portion, or all, of a traditional IRA to a Roth IRA is a surviving spouse who meets the following three criteria:

  1. Low tax bracket
  2. Not dependent on IRA
  3. Has one or more children who are in a high tax bracket

The goal here is to reduce, or potentially eliminate, income tax liability that the surviving spouse’s beneficiaries will incur upon inheriting a traditional IRA since they will be required to take minimum distributions each year from their inherited IRA’s. Anyone in this situation should have a multi-year income tax projection prepared to determine the amount of traditional IRA that should be converted to a Roth IRA in the current and future years while keeping the surviving spouse in a relatively low tax bracket.

While both of these scenarios are not ideal Roth IRA conversion candidates since they could result in a sizeable amount of income tax liability upon conversion, they nonetheless present great opportunities to end up with greater assets than without doing a Roth IRA conversion, especially when beneficiaries are considered.

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IRA Roth IRA

The Ideal Roth IRA Conversion Candidate – Part 1

Retirement Income Center

The last two blog posts, Three Roth IRA Conversion “Show Stoppers” and Clearing the Roth IRA Conversion Hurdles presented three scenarios in each post where the answer to the question, “Should you convert your traditional IRA’s to Roth IRA’s?” was a definitive “no” and “probably not a good idea,” respectively. Assuming that you weren’t eliminated from the Roth IRA conversion game by any of the three “show stoppers” and you cleared all three “high hurdles,” are you a candidate for a Roth IRA conversion?

Whenever you are evaluating candidates, whether it be for political office, employment, or some other situation, you always want to compare the individual against an established ideal candidate profile. In the case of a Roth IRA conversion, the ideal candidate is someone who will incur minimal or no income tax liability as a result of the conversion.

As emphasized in the last two blog posts, a Roth IRA conversion doesn’t have to be an all-or-nothing event – you can do partial conversions. It’s a rare situation when someone with a traditional IRA with a value of $100,000 or more will be able to convert 100% of it to a Roth IRA in a single year without incurring some income tax liability. It’s much more likely that the stars will align in such a way in a particular year that you will be able to convert a portion of your traditional IRA while incurring minimal or no income tax liability.

There are four situations that come to mind where it’s possible to convert a portion, and possibly all, of a traditional IRA to a Roth IRA while incurring minimal or no income tax liability attributable to the conversion. All four situations, in addition to assuming availability of a traditional IRA, require preparation of an income tax projection, including calculation of potential exposure to alternative minimum tax, or “AMT,” to determine the amount of the traditional IRA that should be converted to a Roth IRA to achieve this result.

This blog post will discuss the first two situations, with the second two the subject of next week’s post. The first two situations are as follows:

  1. No current income tax liability without any tax losses
  2. Sale of rental property with large passive loss carry forward and minimal capital gain and depreciation recapture

No Current Income Tax Liability Without Any Losses

You may be in a situation where your itemized deductions and personal exemptions offsets a large portion of your income, excluding losses, so that you aren’t subject to income tax liability. An example would be a retired individual who is less than 70-1/2 who isn’t receiving any sizeable pensions and is taking distributions from nonretirement investment accounts and/or nonqualified income annuities where a large portion of the payments are nontaxable and who also has enough itemized deductions to offset a large portion of otherwise taxable income. If you are in this situation and you have a traditional IRA, an income tax projection should be prepared to determine the amount of your traditional IRA that you can convert to a Roth IRA while still incurring no income tax liability.

Sale of Rental Property With Large Passive Loss Carry Forward and Minimal Capital Gain and Depreciation Recapture

You may own a rental property with a large passive loss carry forward that hasn’t appreciated much in value that you weren’t thinking about selling anytime in the near future. If you are in this situation and provided that a sale of the property won’t result in a large capital gain and ordinary income resulting from depreciation recapture, the sheltering of all of your income from use of your passive loss carryover resulting from the sale of your rental property may significantly reduce, or even eliminate, your income tax liability in the year of sale. If this is the case, an income tax projection assuming sale of the property should be prepared to determine the amount of your traditional IRA that you can convert to a Roth IRA and not incur more income tax liability than you would have incurred had you not sold the property.

If one of these two scenarios applies to you, have your CPA financial planner prepare an income tax projection for you. If the results show that you will incur minimal or no income tax liability in connection with a partial or full Roth IRA conversion, you may be an ideal candidate for a Roth IRA conversion.

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IRA Roth IRA

Three Roth IRA Conversion “Show Stoppers”

Retirement Income Center

Effective January 1st this year, the $100,000 modified adjusted gross income barrier for converting traditional IRA accounts to Roth IRA accounts was eliminated. Now that the floodgates are open and everyone can convert their traditional IRA’s to Roth IRA’s, if you haven’t done so already, should you jump on the bandwagon? While the potential benefits of tax-free withdrawals and not being subject to required minimum distributions (“RMD’s”) (See Year of the Conversion) are extremely attractive, there are several obstacles one must overcome before switching horses.

Before discussing these obstacles, which will be continued in next week’s blog post, it’s important to keep in mind that when contemplating a Roth IRA conversion, it doesn’t have to be an all-or-nothing event. You can, and it’s often preferable, to do partial conversions of traditional to Roth IRA’s over one or more years.

There are three scenarios, in my opinion, that are “show stoppers” when evaluating a potential Roth IRA conversion:

  1. Primary beneficiary of traditional IRA is a charity
  2. 100% of retirement plan funds are invested in an active 401(k) plan
  3. No source of funds for payment of Roth IRA conversion tax liability outside of retirement plans

Primary Beneficiary of Traditional IRA is a Charity

The first thing one should do when considering a Roth IRA conversion is to examine the beneficiary designation of the IRA account(s) to be converted. If the beneficiary is a charitable organization, it generally doesn’t make sense to prepay income taxes if there is a possibility that there will be a tax-free distribution of the IRA to a charity.

100% of Retirement Plan Funds Are Invested In An Active 401(k) Plan

Sometimes people will roll over inactive pension plans, including 401(k) plans, into a traditional IRA and then convert the traditional IRA to a Roth IRA. If you are an active participant in a 401(k) plan, short of borrowing or taking a hardship withdrawal from the plan if permitted by the plan, you are prohibited from taking distributions from the plan prior to attaining age 59-1/2 or separation from service.

No Source of Funds for Payment of Roth IRA Conversion Tax Liability Outside of Retirement Plans

Assuming that you aren’t one of the fortunate individuals who is able to do a tax-free Roth IRA conversion, after calculating the potential income tax liability attributable to your conversion, you need to ask yourself the following question: What will be the source of payment of the income tax liability attributable to your Roth IRA conversion?If you don’t have sufficient funds in checking, savings, money market, and other nonretirement investment 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.

When you incur income tax liability in connection with a Roth IRA conversion, you always want to pay the income tax from funds outside of retirement plans, including the traditional IRA being converted. If you elect to have income tax withheld from your traditional IRA being converted to a Roth IRA, in addition to reducing the amount of the conversion by the amount of income tax withheld, if you are under age 59-1/2, you will be subject to a 10% premature distribution penalty on the amount of withholding since it is considered to be a distribution from your IRA that is not converted to a Roth IRA within 60 days.

Paying the tax from other retirement plans is also self-defeating since the funds will no longer continue to grow tax-deferred, there will be a taxable distribution, and, to the extent that you are under age 59-1/2, you will be subject to a 10% premature distribution penalty on the amount of the distribution.

If the primary beneficiary of your traditional IRA account isn’t a charitable organization, 100% of your retirement plan funds aren’t invested in active 401(k) plans, and you have funds outside of retirement plans to pay the income tax liability attributable to your Roth IRA conversion, put on your running shoes and get ready to run the high hurdles in Clearing the Roth IRA Conversion Hurdles, the topic of next week’s blog post.

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Roth IRA

Roth IRA – Retirement Plan Holey Grail?

Retirement Income Center

With all of the buzz in the investment/retirement planning community about Roth IRA’s as a result of the January 1st elimination of the $100,000 modified adjusted gross income threshold for converting a traditional IRA to a Roth IRA, you would think that they’re the only game in town. Although the two main attractions of a Roth IRA that were introduced in last week’s blog post, Year of the Conversion, i.e., nontaxable distributions and no required minimum distributions (“RMD’s”), are two desirable benefits of any retirement plan, there is a price you must pay to obtain them.

The Ideal Retirement Plan

In order to understand the Roth IRA club entry fee, let’s take a step back and examine the eight features of an ideal retirement plan to see which ones are present or lacking in a Roth IRA:

  1. Contribution ability not subject to income test
  2. Fully deductible contributions
  3. Unlimited contribution amounts
  4. Nontaxable income
  5. Nontaxable distributions
  6. Distributions at any age without penalties
  7. No required minimum distributions
  8. No income tax liability upon conversion to the plan

Contribution Ability Not Subject to Income Test

Unlike other types of retirement plans, potential IRA owners must clear an income hurdle in order to be eligible to make contributions. If your adjusted gross income exceeds specified limits, which are different depending upon your filing status, then you won’t be allowed to make a contribution to either a traditional or Roth IRA.

Fully Deductible Contributions

Contributions to plans that are used directly and indirectly for conversion to Roth IRA’s are often, but not always, fully deductible. These include traditional IRA’s, SEP-IRA’s, 401(k) plans, profit sharing plans, and defined benefit plans. This is an extremely important benefit not to be overlooked, particularly if you’re in a high marginal income tax bracket when making contributions to these types of plans. Roth IRA contributions, on the other hand, are never deductible.

Unlimited Contribution Amounts

In addition to being fully deductible, allowable contribution amounts for certain retirement plans, such as defined benefit plans, while they aren’t unlimited, can be quite generous, particularly for highly-compensated older employees. In addition to being nondeductible, Roth IRA contributions are currently limited to $5,000 per year, or $6,000 if 50 and above.

Nontaxable Income

All retirement plan participants enjoy the benefit of nontaxable income while funds remain in the plan. This includes interest, dividends, and realized gains from securities sales that would otherwise be taxable if the same investments were held in a nonretirement plan.

Nontaxable Distributions

As pointed out in Year of the Conversion, whenever a deduction is allowed for contributions to a retirement plan, whether it be an IRA, 401(k), or some other type of pension plan, withdrawals from the plan are taxable as ordinary income just like salary. As also mentioned in last week’s post, since contributions to a Roth IRA aren’t deductible, withdrawals generally aren’t taxable provided that they remain in the plan for five years after the Roth IRA owner established and funded his or her first Roth IRA account, or, in the case of a Roth IRA conversion, five years from the date of conversion, and the owner is at least 59-1/2.

Distributions At Any Age Without Penalties

To promote the fact that retirement plans are intended to be used for retirement, distributions from retirement plans before age 59-1/2 are generally subject to a 10% federal premature distribution penalty plus potential state penalties. This includes distributions from Roth IRA conversions.

No Required Minimum Distributions

In exchange for tax-deductible contributions and nontaxable income while funds remain in a plan, IRS requires you to begin withdrawing funds, otherwise known as required minimum distributions, or “RMD’s,” from plans at a specified age, generally age 70-1/2, or be subject to a 50% penalty on RMD’s not distributed. While Roth IRA’s escape this requirement during the owner’s lifetime, Roth IRA beneficiaries are required to take minimum distributions from their inherited plans.

No Income Tax Liability Upon Conversion to the Plan

When you convert, or roll over, company pension plans, such as 401(k) plans, profit sharing plans, and defined benefit plans to a traditional IRA, there’s generally no income tax liability assessed upon conversion. Roth IRA conversions, however, are fully taxable as ordinary income with the exception of funds originating from nondeductible IRA contributions.

Depending upon facts and circumstances, assuming you have the funds available outside of your retirement plans to pay it, in many cases, the income tax liability associated with a Roth IRA conversion won’t outweigh the potential benefits one might potentially receive from a Roth. Even though Roth IRA’s share many of the eight desirable features of an ideal retirement plan, as you can see, they aren’t the holy grail of retirement plans, and, depending on your situation, may in fact, end up being the “holey” grail for you.