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You’ve spent years accumulating money for retirement in tax-deferred accounts. But you may have forgotten that the government has a permanent tax lien on those accounts and plans to collect when you withdraw your money in retirement. Fortunately there’s a tax-free investment vehicle that may give you greater flexibility and control: the Roth IRA. Starting in 2010, for the first time, all investors, regardless of income, can convert their tax deferred funds into a Roth IRA. But this opportunity raises some interesting questions: will a conversion produce tax advantages, what about partial conversions, is it better to do multiple annual conversions or a single conversion in one calendar year?

First, a little background on IRA’s. These accounts are designed for retirement savings and offer the advantage of tax deferral. Earnings such as interest, dividends and capital gains accumulate without the burden of taxation. Second, contributions are typically made with pre-tax dollars. If you are in a 25% tax bracket and you contribute $5,000 to your IRA, your tax bill will be reduced by $1,250. In effect, it costs you $3,750 to add $5,000 to your IRA. Not a bad deal at all!

Although valuable, these advantages are not permanent. Withdrawals from traditional IRA’s are taxable. And even if you don’t need the money, the IRS mandates that you begin to make withdrawals once you reach the age of 70 1/2.

In contrast, contributions to Roth IRA’s are made with after-tax dollars and “qualified” withdrawals are completely tax-free. Generally speaking, withdrawals are “qualified” if the Roth IRA is open for five years and the owner is at least 59. Another important advantage of the Roth is there are no mandated distributions. This means the account can grow for a lifetime on a tax-deferred basis. You or your heirs can make withdrawals completely free of taxation.

Now, let’s get back conversions. Whereas in prior years there was an income limitation, starting in 2010, any taxpayer, regardless of income, can do a conversion. A conversion means that you transfer funds from your traditional IRA to your Roth IRA. It also means that you will have to pay tax on the amount transferred. For example, if you are in a 25% tax bracket and you convert $100,000, the tax relating to this conversion would be $25,000. For conversions made in 2010, there is a one-time opportunity to spread out the tax impact over calendar years 2011 and 2012.As a financial advisor (and a taxpayer), I am always looking for opportunities to defer taxation. Why pay taxes now when you can pay them later? Why not generate a return for yourself by investing the funds that would have otherwise gone to the government? The idea of doing a conversion and accelerating the payment of tax does seem to go against the grain.

Nevertheless, in certain circumstances, a Roth conversion can be advantageous. Let’s look at a few opportunities for tax leverage (a fancy way of saying a tax advantage as compared with not doing a conversion).

• Tax rate differential. If you anticipate your future tax rate will be higher than your current rate, a Roth conversion could make sense. In essence, you would be paying tax today at a lower rate to avoid paying tax at a higher rate when withdrawals are made in the future. Many believe that the federal government’s high level of spending and the historically high outstanding debt will ultimately require significant tax rate increases. A Roth conversion can hedge against this possibility.
• IRA gross-up. Let’s assume you own a traditional IRA and your most recent statement shows a value of $100,000. Do you really have $100,000 in purchasing power? If you are in a 25% tax bracket, the government in effect has a $25,000 lien on your account. You can only spend $75,000. Conversion to the Roth grosses up the traditional IRA. $100,000 in a Roth means that you can actually spend $100,000. So, an apples-to-apples comparison of purchasing power would equate a $100,000 traditional IRA plus $25,000 in a taxable side account with $100,000 in a Roth IRA. Going forward in time, the advantage goes to the Roth as it will be more efficient. It grows completely free of taxation whereas the $25,000 in the side account is subject to ongoing taxation.
• Roth legacy planning. Traditional IRA owners are required to make annual taxable distributions starting at age 70 1/2. For many, this is not an issue as they plan to withdraw at least the minimum required amount anyway. However, there are others who would prefer not to make any withdrawals. They wish to earmark their retirement assets for the benefit of their heirs. The Roth IRA is ideal for this purpose. It can grow tax-deferred during the owner’s lifetime without any impairment from required distributions. And the heirs, even though they will have to make mandatory distributions, will never pay income tax on these withdrawals. For taxpayers subject to state and federal estate taxes, a Roth conversion can do double duty. The prepayment of income taxes upon conversion reduces the size of the taxable estate. It’s the equivalent of making a tax-free gift. The heirs not only receive a tax advantaged Roth account, but estate taxes are reduced or eliminated.
• College funding strategy for grandparents. Here’s how it works. The grandparent converts a traditional IRA to a Roth, earmarks the Roth for the grandchild’s future education costs and makes the grandchild the primary beneficiary. This arrangement has several advantages. First, during the grandparent’s lifetime, there are no required distributions. Second, the grandparent controls the account and has complete flexibility as to when, how, and for whom it is used. When funds are provided to the grandchild, there is no income tax (as long as the distributions are qualified). Since the account is owned by the grandparent (and not by the grandchild or the parent), the account is not reported as an asset for purposes of need-based college financial aid (i.e. it is not reported on the FAFSA form). In the event of the grandparent’s death, the account is inherited by the grandchild who can withdraw funds for college education costs on a tax-free basis.

What if the assets you convert to a Roth decline in value after the conversion? This would be a classic case of adding insult to injury. Not only do you suffer from a decline in the value of your investments, but you have to live with the fact that you voluntarily paid taxes on a value that no longer exists. Have no fear, you can have a “do over” by using a process called recharacterization. You have until October 15 of the year following the year of the conversion to undo the conversion and get a refund of the taxes you paid. And if you are so inclined, you can then try the conversion again. Whoever said the IRS doesn’t have a heart.

Tax leverage from a Roth conversion, when available, accrues to the taxpayer in the future and the future is always uncertain. Roth conversion rules are complex. There are many interrelated factors to consider and numerous pitfalls to avoid. If you think that tax-free income from a Roth IRA might work for you or your heirs, be sure to do a thorough analysis and consult with a competent tax or financial professional.

Bud Levy, CFP®, CPA, MBA is an advisor with NestEgg Advisors, Inc. (www.nesteggadvisors.net), a financial planning firm in Long Island, New York. Bud can be reached at budlevy@nesteggadvisors.net. Securities through American Portfolios Financial Services, Member SIPC.
 

Bud Levy can be contacted at (631)952-2177  www.NestEggAdvisors.net