Roth IRA Conversion Evaluator®: Frequently Asked Questions



Roth IRA Conversion Evaluator®: Frequently Asked Questions --Version 1.0

Download of Version 2.0

Question: Are users required to download Version 2.0?

Answer: Users will be prompted to download Version 2.0. On June 1, 2010, the update prompt will change from non-required to required and users will not be able to run the Evaluator until they perform the update.

Functionality

Question: How do you account for basis in a non-deductible IRA?

Answer: Version 1.0 of the Evaluator does not include an input field for basis in a non-deductible IRA. This is addressed in Version 2.0. For those using Version 1.0, a temporary solution is suggested below:

PROCEDURE

STEP 1:  Open up “Tax Rate Evaluator” within the Roth IRA Conversion Evaluator.

STEP 2:  Enter all of your miscellaneous income and deduction assumptions (except for the Roth IRA conversion amount).

STEP 3:  Enter the desired Roth IRA conversion amount LESS the amount of “basis” that is attributable to the conversion. (For example, if the desired Roth IRA conversion amount is $100,000 with $10,000 of “basis” attributed to it, then in the “Roth IRA Conversion” assumption box enter $90,000.)

STEP 4:  Click “Calculate“.

STEP 5:  Refer to the “TOTAL INCOME TAX” line of the Tax Rate Evaluator (towards the bottom of the analyzer printout to the right of the assumptions). Subtract the total income tax amount in the right column (i.e. “After Roth IRA Conversion”) from the total income tax amount in the left column (i.e. “Before Roth IRA Conversion”). NOTE: This amount is the “incremental income tax liability” associated with the Roth IRA conversion.

STEP 6: Divide the result from STEP 5 into the total Roth IRA conversion amount WITHOUT REGARD to the “basis”.

STEP 7:  Enter the resulting tax rate in the “Ordinary Income Tax Rate on Roth IRA Conversions” box on the Assumptions page under the respective Option for which the calculation applies.

*****EXAMPLE*****

Assume the following inputs:

Filing status: Married filing jointly

Number of personal/dependency exemptions: 2

# Age 65 & Over: 0

# Blind: 0

Other ordinary income: $50,000

Qualified dividends: $10,000

Real estate taxes: $3,500

Home mortgage interest: $8,500

Gross charitable contributions: $2,000

Total Roth IRA conversion amount: $100,000

“Basis” attributable to Roth IRA conversion amount: $10,000

(NOTE: As a result the Roth IRA conversion having “basis”, the entry in the Roth IRA conversion assumptions box would only be $90,000.)

Based on the above inputs, below are the results and what would be entered in the “Ordinary Income Tax Rate on Roth IRA Conversions” box for Option 2 on the Assumptions page:

Total income tax – Before Roth IRA conversion: $3,467

Total income tax – After Roth IRA conversion: $23,537

Difference (i.e. “incremental income tax liability”): $20,070

Total Roth IRA conversion amount: $100,000

Incremental income tax rate on conversion: 20.07% ($20,070 / $100,000)

Question: How do you account for the impact of state taxes on the Roth IRA conversion?

Answer: To take into account the impact of state taxes on the conversion, the user will need to add the appropriate percentage to that assumed for federal taxes. In other words, if the otherwise assumed federal rate is 35 percent, and the state rate would be 5 percent, the user should input 40 percent as the applicable rate.

Question: Assuming a client has an investment portfolio consisting largely or wholly of tax-exempt securities. How should such a portfolio be reflected?

Answer: Version 1.0 of the Evaluator does not have a separate input field for tax-exempt assets. In lieu of that, the user should consider whether or not the client intends to use these investment funds.

If the client does not intend to use the funds, then set the growth rate for the portfolio at the actual tax-exempt rate (e.g., 4.5%), the asset turnover to zero, and the distribute yield option to “no.”

If the client intends to use the funds, set the growth rate at zero, the yield at the tax equivalent rate (e.g., 6.0%), and the distribute yield to “yes.”

This is addressed in Version 2.0.

Terminology

Question: What is meant by Annual Asset Turnover?

Answer: The Asset Turnover Ratio relates to the portion of the investment account that is going to be sold off each year. If the intention is to use the investment account, such as to pay taxes on the conversion and/or to make up a shortfall between the annual income and after-tax cash needs, the Asset Turnover Ratio should be set to a positive number. The general assumption in the Evaluator is that if “Other Income” plus the annual “Yield” and “Asset Turnover” for the Taxable Investment Account are insufficient to cover the annual after-tax cash flow needs, then it is assumed that the traditional IRA is tapped into first, followed by the Roth IRA. As a work-around to this general logic assumption, the user can set the annual asset turnover higher (possibly up to 100%) to tap into all of the Taxable Investment Account first if “Other Income” by itself is insufficient to cover the annual after-tax cash flow needs.

Question: In the Tax Rate Evaluator tab, what is meant by the “effective ordinary income tax rate?”

Answer: The effective ordinary income tax rate is the total tax liability divided by gross income, expressed as a percentage.

Question: What is meant by Net-to-Family?

Answer: The Net-to-Family amount is derived from a “tax affecting” calculation that assumes liquidation of the accounts at a particular point in time based on assumptions pertaining to the estate tax and the beneficiary’s future income tax rates (built-in-income tax on traditional IRA) that the user has made on the Assumptions tab. Look at the Assets tab for Option 1 (the Do Nothing option) and compare that to the Assets tab for any of the Roth options (Options 2 through 6) to see how that number is derived. The calculation reflects the impact of the Code Sec. 691(c) deduction for estate taxes paid on items of income in respect of decedent (IRD), such as an IRA.

For further information on the Net-to-Family calculation, users should consult the document “Understanding the Present Value of Future IRA Distributions” found on IntelliConnect (Document Path: Financial and Estate Planning - Roth IRA Conversion Expert™ - Professional Practice Management – Understanding the Present Value of Future IRA Distributions).

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Question: What is the significance of the variance and step analyses?

Answer: The variance and step analysis features in the Summary tab allow the user a point of comparison, based on either a dollar amount or a percentage, to compare the Net-to-Family results between (1) the selected Roth conversion options (Options 2 through 6) and the “do-nothing option” (Option 1) (variance) and (2) between the various (up to five) Roth conversion options (step). While the charts allow the user to see these comparisons at the 10-, 20-, or 30-year time points, the summary allows the user to see the specific annual points when a particular Roth conversion option can produce a positive or negative result.

Assumptions

Question: What effect on the output will putting an amount in the Real Estate field of the assumptions screen have on the output?

Answer: Real estate, and any growth from it, will be reflected specifically on the Assets tab. It will, in turn, be part of the IRA owner's gross estate, which impacts the Net-to-Family figure that appears in the charts and the summary.

Question: Can the choice of yes/no as to whether the payment of taxes on conversion will be paid from the Roth IRA be overridden by other facts assumed in the analysis?

Answer: Yes, for example, if the combination of other income (minus the after-tax cash needs) and the yield and asset turnover from the outside investment account are sufficient to pay the taxes, the taxes will be paid from outside of the Roth regardless of what choice is made. The converse is also true in that, if there is no other source of funds to pay the tax, the tax will come from the Roth regardless of the yes/no choice.

Question: Does the program assume a “draw-down” date for distributions to begin from the Roth IRA?

Answer: There is no assumed or selectable "drawn down date" for the Roth. The Evaluator assumes required minimum distributions (RMDs) from the traditional IRA beginning at age 70. It is possible to force distributions from the Roth by creating a situation in which the after-tax cash needs exceed the annual income and the outside investment account is insufficient to meet these needs. However, this would be counterintuitive to the idea of trying to shield the Roth from distributions for as long as possible.

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