Roth Conversion- that is the question for 2010

Only a handful of times in financial planning do we see a legislative change that will impact individuals and their heirs for decades to come. It allows for any individual to convert all or some of their assets in a conventional IRA, 401(k) and 403(b) accounts to an after-tax Roth accounts in 2010 and forward. Prior to 2010, single filers making more than $105,000 and joint filers making more than $176,000 were not allowed to make the conversion. The legislation that bore this opportunity is the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). TIPRA is also the same legislation that allowed after-tax 401(k) contributions or better known as the Roth 401(k). (To read more on Roth 401(k) go here.)The extra benefit of converting in 2010 is half of the tax liability can be paid in April 2011 (2010 tax year) and the other half in 2012 (2011 tax year). Now that I have hyped the opportunity, a Fidelity Investments survey found only seven percent of individuals polled expect to make any conversion.

Does converting save taxes?

There is no easy answer to this question, because it revolves around government regulation. The open answer depends on whether you feel these dollars will be taxed at a lower rate today than in the future. We can run several scenarios, but it will ultimately fall back on tax rates used in the assumptions.

So what do we do know about tax rates?

As the law is currently written, the tax cuts passed in the Bush administration will sunset on December 31, 2010. Our current tax rates will revert back to 2001 rates, causing most everyone’s taxes to increase by a few percentage points. This brings an additional question into play for those that choose the Roth Conversion: do I pay all of the tax on my 2010 taxes or split between two years with the potential for the later year’s tax rates to increase. Luckily, you do not have to declare how much you want to split if you choose to do the conversion until your 2010 taxes are due. So hopefully by early 2011, we will know what Congress will do on the sun setting tax rates.

In summary, with the Bush tax cuts set to sunset, increasing deficits and the lack of funding on benefits promised in Social Security and Medicare, tax rates will not go lower with the high possibility of moving higher.

Are there other benefits to converting besides taxes?

Yes, there are several benefits for certain individuals. Some of these are no required minimum distributions at 70 ½, easier distribution rules for early withdrawals once the account is open for five years, tax diversification, and helping to simplify estate planning.

Required Minimum Distributions

I have always said that an IRA or 401(k) plan is a good way to save money, until you accumulate wealth outside of the plan. At the age of 70 ½, individuals are required to take a minimum amount from their IRAs whether they want to or not. Roth IRAs have no required minimum distribution. This allows individuals to take the distributions when needed and not forced by the distribution rules.

Distributions from Roth IRAs

After a Roth IRA has been open for five years or longer, an individual can withdrawal their contributions without penalty or tax. Unlike conventional IRAs, the first dollars drawn from a Roth Account are deemed to be the contributions. So in reality, an individual can draw as much as they have contributed to their Roth IRA at anytime (after the 5 years) for anything without tax and penalty. In discussing the Roth Conversion, the amount converted will be deemed contributions, since taxes will be paid. This will allow individuals who have not had the chance to contribute to a Roth IRA to not only change the tax rates of future earnings, but also open this money up for different uses.

For example, a parent is planning to save money for a child’s college education. In addition to 529s, UTMAs and college savings plans, the parents can use portions of the Roth IRAs to pay for college. This will allow assets to continue to grow in the parents name should the child get a scholarship or choose not to attend higher education.

Tax Diversification

If you have read any financial planning piece of information in the last thirty years, you have heard of diversification. However, most people talk about asset diversification and few people talk about tax diversification. To explain tax diversification, let me give you a few tax rates on some investments: capital gains on stocks – 15%, dividends – 15%, interest from bonds – ordinary income (this could range from 10%-35%). In conventional IRAs, we pay the ordinary income tax rate on any distributions, thus contributions, capital gains, dividends and interest earned are taxed at ordinary income rate when taxed.
If we have a stock, who pays a dividend that is normally taxed at 15% in an IRA, when distributed to us this dividend has a high possibility of being taxed at a rate higher than 15%. Assume an individual has $500,000 with half in an IRA and half in a regular account. This individual’s asset allocation calls for 50% stocks and 50% bonds. This individual should buy all the bonds in the IRA in order to avoid paying ordinary income rates on dividends and capital gains. (Note: this assumption assumes the individual is buying taxable bonds and not municipals.)

An individual converting to a Roth creates new planning opportunities with tax diversification. If we assume the above individual chooses to convert part or all of his IRA and pays the tax with part of the taxable account, he has moved a portion of two asset types to a tax free investment vehicle.

Estate Planning

When an individual accumulates wealth and part of the wealth is a tax-deferred asset, this asset could be taxed both by estate taxes and income taxes at a combined rate above 60%. If you refer to Roth 401(k): Better for Heirs, it will explain in more detail the benefit of Roth savings to heirs. Briefly, an individual who inherits a Roth IRA will not owe any income tax on the IRA. Estate tax may be owed. The only requirement of the beneficiary is that they take tax free distributions from the Roth based on their life expectancy.

Summary

It is difficult to determine the ultimate tax benefits of a conversion; however what is not difficult is that a conversion opens many beneficial planning opportunities as well as questions. There is no blanket yes/no answer on the conversion. Some will convert all, others none, and a portion will convert part of their IRAs. As you are reviewing your financial plan or goals, we will be more than happy to assist you in the decision making process.

If you have any questions, please contact either Guy at (270) 846-0405 or Alan at (859) 239-9000.

General Note on 401(k) conversion: No matter what the new law says; money in a plan is still subject to the rules of the plan. Most plans do not allow in service rollovers (rolling out of the plan while an active participant), especially for participants under 59 ½. So, even if the new law says you can roll from a plan to a Roth IRA, your plan document probably does not allow it while you are an active participant.