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Lincoln Institute


Making Cents of Roth IRA Conversions

by Doug Keegan
 

This is a transcript of Doug Keegan's Making Cents segment on this week's Lincoln Radio Journal:

Beginning in 2010, the rules surrounding Roth conversions will change, allowing everyone to be eligible. But just because you can convert, doesn't mean you should convert. Doug Keegan of Harris SBSB is here to explain.

Before we talk about Roth conversions, you wanted to let everyone know about a new IRS ruling that allows relief for IRA owners.

That's right, Lowman. On September 24th, the IRS issued Notice 2009-82, which provides tax relief for IRA owners who received unwanted 2009 required minimum distributions. If you took an unwanted 2009 required minimum distribution, you now have the chance to put back those funds without penalty and avoid income tax due on that money.

Why is the IRS allowing this? Back in 2008, Congress waived the distribution rule for 2009. But the legislation was not enacted until December, causing some people to take withdrawals that weren't required. As a result, the IRS has decided to permit any IRA owner to undo it, regardless of when they took it. So if you took an unwanted 2009 required minimum distribution, you now have until November 30th, I'll repeat, November 30th, to put back those funds without penalty.

Let's get to our topic, Roth conversions. What is a Roth conversion?

A Roth conversion is where you take a traditional IRA, IRA rollover, a SEP IRA and even a non-deductible IRA and simply transfer it to a Roth IRA, thus "converting" it. Income taxes will be due, however, on the amount you convert if you previously have taken a tax deduction for the IRA contributions.

So what is changing in 2010 with regards to Roth conversions?

Starting in 2010, taxpayers making over $100,000 get a special tax break. Anyone, regardless of income, can convert to the Roth IRA. Previously, your adjusted gross income had to be below $100,000. In addition, if you convert in 2010, you get to spread the tax payment over 2011 and 2012 instead of having to pay it all in one year.

Now removing the Roth conversion cap doesn't mean anyone can fund a Roth IRA, income limitations on contributions still apply, but it does mean that anyone can convert to a Roth IRA.

This rule change was part of a tax act that President Bush signed into law in 2006. It was passed as a budget reconciliation bill and pertained specifically to the 2005 federal budget. The conversion provisions were written, by design, as revenue offsets for the budget bill, thus reducing its total cost. The primary reason for the conversion rule change was to accelerate the collection of income taxes.



Doug you mentioned the Roth IRA and the traditional IRA, how do they differ?

In a traditional IRA, depending upon income limits, you get a current tax deduction for the contribution and your account grows tax-deferred. This means that taxes are due when the money is taken out. In a Roth IRA, you don't get a current income tax deduction, but the earnings come out tax-free.

In addition, the Roth IRA has a lot of escape hatches, which the traditional IRA doesn't have. First of all, since you have already paid taxes on your contributions, all of the contributions are yours to take out tax-free and penalty-free. Also, Roth IRA owners don't have to worry about being forced to take money out when they turn 70 ½, unlike traditional IRAs.

So when does a Roth conversion make sense?

Lowman, the decision to convert, or not to convert, is not as easy as it may first appear. It really depends on each taxpayer's individual situation. There are just too many unknowns such as future tax rates, investment returns, and planning horizon. In fact, the topic is so complex I wrote a white paper for my firm so we could help our clients' navigate their way through the decision-making process. So there's nothing automatic about the conversion decision.

And if I may, I need to warn everyone. There's a lot of news in the general press and in my industry about Roth conversions because of the rule change. In fact it's creating a buzz. But I'm concerned. If a financial advisor tells you to convert to a Roth, please don't assume that it's something you should naturally do. Be aware that many in my industry are encouraging advisors to use the Roth conversion as a marketing tool. The fact is many IRA owners will not do well with a Roth conversion. So before you convert, make sure your financial advisor has done a detailed, projected tax analysis of your situation, demonstrating to you, without doubt, that it's a smart financial move. Having said that, here are few rules of thumb to help guide you:

Rule #1: If you have negative taxable income, unutilized tax attributes, or lower income in any given year, a Roth conversion makes sense. I'll give you an example. Let's say you have a huge medical bill this year. When you itemize, you can right that off as a tax deduction. But let's assume because of other deductions and exemptions, you have negative taxable income and will lose some of that medical deduction. Well, by converting a portion or all of your traditional IRA, you can generate enough taxable income to utilize the rest of that medical deduction, resulting in no income tax. So essentially, you moved money out of a taxable account and into a tax-free account without generating a tax bill. That's pretty cool.

Rule #2: If you think you will be in the same or higher tax bracket at retirement, have a long time horizon for the assets to grow tax-free, and can pay the income tax with cash outside the IRA, not from the IRA, but with cash on hand from another source, then a Roth conversion may make sense.

Rule #3: If you are a high net worth individual, you may find that converting part or all of your traditional IRA may be advantageous for estate and legacy planning purposes, especially if there is a significant IRA balance and if you are subject to state estate taxes.
But even with these rules of thumb, you need to be aware of several things:

When you do a conversion, make sure it doesn't bump you up into a higher tax bracket. That just defeats the purpose.
When looking at future tax rates, remember it may not be just your tax rate it could be your surviving spouse's tax rate or your kids' tax rate. If the money goes to your surviving spouse, tax brackets are narrower for single filers so a conversion may make sense. But if it's for your kids and they're in a lower tax bracket, it may not make sense for you to pay the income tax now.
Finally, consider state taxes. Pennsylvania for example doesn't impose an income tax on traditional IRA withdrawals. Other states do. So look at your total tax bill, not just federal taxes.

Lowman, the bottom line is this: we have no clue where tax rates will be in the future or what Congress will do. Remember, higher future taxation in general doesn't mean a higher tax rate on IRA withdrawals. There are many other ways Congress can get money, including a national sales tax, a value-added tax or a payroll tax increase. So again, just because you can convert doesn't mean you should convert.

Let's say if someone does a Roth conversion and the account balance goes down because of the market. This sort of negates the strategy, right? So what can these people do?

The Roth conversion is one of the great second chances in the tax code. It's kind of like getting to bet on a horse after the race is over. You can recharacterize or undo a Roth conversion, and it will be treated as if it never happened. And if you paid tax on the conversion, you can recoup that tax and get all that money back plus interest. So yes, if after a Roth conversion your account balance drops, you can always undo it and start again. But you have to make sure you follow the rules, so get you tax accountant or financial planner involved.


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