Pay Me Now or Pay Me Later?
Roth IRA Conversions
The tax advisor community is excited all over again about Roth IRA conversions. If qualified, a client can take a regular old IRA and convert it to a Roth IRA. The amount converted is treated like ordinary income to the client in the year of the conversion, so there is an immediate income tax to pay on the money. Why in the world would anyone volunteer to pay more tax?
Three Benefits
Well, there are at least three very important benefits to a Roth IRA:
- Retirement withdrawals from the new Roth IRA are not subject to income tax after the conversion. At retirement, the client can withdraw the converted balance and all the accumulated dividends, interest, and capital gains from the Roth IRA free of income tax.
- There is no requirement that the account owner must begin withdrawals at age 70 ½ like a regular IRA. The client can continue to accumulate wealth in the Roth IRA until death.
- The benefit of tax-free withdrawals from the Roth IRA passes along to the beneficiaries of the original account holder. The Roth account can be transferred income tax-free from generation to generation.
The New Law
Up to now, only taxpayers with adjusted gross income (AGI) less than $100,000 could even qualify to make a conversion. Beginning January 1, 2010, there is no AGI limitation. Anyone at any income level can make the conversion. Should the client line up at his or her investment advisor’s door on January 4th to make the change?
I hate to resort to the tax lawyer two-step, but the answer depends on a host of factors. How close is the client to retirement? What other assets does the client have? Will the client’s marginal tax rate be lower or higher after retirement? Will overall tax rates rise or fall? What is the marginal tax rate for the client’s beneficiaries? What is the client’s tolerance for investment risk? The issue is quite complicated, and it cries out for careful, individual analysis.
A Word of Caution
The client would be wise to proceed cautiously. Crainiac Mike Grant poses this nightmare scenario: What if the client is in the top income tax bracket when he or she makes the Roth conversion? The client takes an immediate 35% federal haircut on that account. And what if the stock market tanks 40% again this year? Suddenly the client finds the retirement fund reduced to 39% of its original value. That is a lot of ground to make up, even on a completely income tax free basis.
Great Flexibility
If the client ultimately decides to pursue this opportunity, he or she will have great flexibility in this area. There is no requirement that the client must convert all regular IRA balances to Roth IRAs, and less may be more in this instance. The client can consider a conversion of a small portion of the regular IRA to a Roth, and see how it works. If the client responds to the idea of a completely income tax-free account, the client can convert more later. If the conversion is unsatisfactory, the client can unwind the conversion by transferring the Roth IRA back to a traditional IRA account. This “recharacterization” is available up to the due date (including extensions) of the client’s tax return for the year of the conversion.
Why Wait Until Next Year?
In this economy, some of my clients are comfortably under the $100,000 AGI limit for this year, and some have losses. A Roth conversion offers an alternative to carrying those losses back to previous years or forward to future years. The client might consider deliberately increasing AGI, even up to the $100,000 limit, with a Roth conversion. At that level of AGI, the client’s marginal federal tax rate should fall in the 25% range. This would be a full 10% off the top 35% rate that high income taxpayers usually face.
Even if the client overshoots the AGI cap, the recharacterization technique is still available. The client has up to 9 ½ months after year-end to pull the AGI back down.
Call Me
The Roth IRA conversion offers a wonderful tax break under the right circumstances. If you have questions about its possibilities, please give me a call.
J. Kevin Crain
CRAIN LAW FIRM, LLC 636-G Long Point Road #95 Mt. Pleasant, South Carolina 29464 Phone (843) 735-7602 Fax (843) 735-7002 Mobile (843) 327-7744 Email kevin@kevincrain.com