Leimberg’s - SFSP



Leimberg’s

Think About It

Think About It is written by

Stephan R. Leimberg, JD, CLU

and co-authored by Linas Sudzius

November 2009 # 405

ROTH IRAs:

THE GREAT OPPORTUNITY

Introduction

Those who are saving for retirement may have to sort through a confusing set of strategies, including:

• Employer-provided qualified plans

• IRAs

• Social security benefits

• After-tax personal investments

Each of these strategies may have an equally bewildering sub-set of choices.

Take IRAs for example. Employers may help employees fund traditional IRA accounts through a SEP plan. Traditional personally-funded IRAs may allow deductible or non-deductible contributions. And many taxpayers have to decide whether traditional or Roth IRAs are the best choice.

In 2010, the rules with regard to Roth IRAs are changing. More taxpayers will be eligible to convert their traditional IRAs to Roth IRAs. The change will cause clients to ask questions that financial professionals will need to be prepared to answer. The key question for most will be this:

Is it better to keep my traditional IRA, or should I convert to a Roth IRA?

The answer depends on the client’s goals with regard to

• Current income tax results,

• Retirement income,

• Family wealth distribution, and

• Tax timing.

Roth IRA Characteristics

Roth IRAs have been highly popular since their introduction as part of the Taxpayer Relief Act of 1997.

Taxation

A personally-funded traditional IRA allows a taxpayer to save for retirement on a tax-favored basis. If the taxpayer’s income is below certain adjusted gross income thresholds, the amount contributed may be tax deductible. The traditional IRA grows tax-deferred, and amounts distributed from the IRA are generally taxable when received. Early distributions may be subject to a 10% penalty tax.

Contributions to a Roth IRA are always after-tax. Like a traditional IRA, a Roth IRA accumulates on a tax-deferred basis. Unlike a traditional IRA, qualifying distributions from a Roth are income tax-free.

A qualifying distribution occurs when an individual takes a distribution following a five year period beginning with the taxable year in which that individual first made a contribution to any Roth IRA in the taxpayer’s own name and one of the following is met:

(1) the distribution is on or after the owner attains age 59-1/2,

(2) the distribution is made to a beneficiary after the death of the owner,

(3) the distribution is on account of the owner’s disability, or

(4) the distribution is a qualified first-time homebuyer distribution.

The ability of the taxpayer to access Roth money on a tax free basis with qualifying distributions is what makes Roth IRAs so attractive.

All other Roth IRA distributions are non-qualifying. Non-qualifying Roth IRA withdrawals are made according to the following ordering sequence: (1) aggregate annual contributions, (2) conversion amounts, (3) earnings on annual contributions and conversion amounts.

Here’s a non-qualifying distribution example:

Sally started her Roth IRA by converting $25,000 in a traditional IRA into her Roth and has since made annual contributions totaling $20,000. The Roth IRA currently has a balance of $55,000; therefore there are earnings of $10,000. If Sally takes distributions from her Roth IRA, the first $20,000 out will be considered return of her annual contributions, the second $25,000 will be considered distribution of conversion money, and the final $10,000 out will be earnings.

Distribution of annual contributions is always income tax-free and is never subject to the 10% early withdrawal penalty. The distribution of conversion amounts is also income tax-free, but these amounts may be subject to the 10% early withdrawal penalty if made within five years of the conversion and while the owner is under age 59-1/2.

The penalty tax on conversion amounts is in place to prevent people under age 59-1/2 from doing a Roth conversion, and then immediately liquidating the new Roth IRA in an attempt to circumvent the 10% penalty.

Earnings distributed prior to age 59-1/2 are subject to the 10% early withdrawal penalty unless the distribution is:

• made to a beneficiary upon the death of the owner,

• made because of the owner’s disability,

• used for qualified medical expenses,

• used to pay health insurance premiums by an unemployed owner,

• used to pay qualified higher education expenses,

• a qualified first-time homebuyer distribution, or

• part of a series of substantially equal periodic payments based on life expectancy.

Contributions

For those who are married and filing jointly in 2009, the taxpayer can make a full Roth IRA contribution--$5,000 if younger than 50, $6,000 if 50 or older--as long as modified adjusted gross income (MAGI) is below $166,000. For married taxpayers, the ability to contribute to a Roth IRA phases out entirely at $176,000. For single filers, the thresholds are $105,000 and $120,000.

Roth IRA contributions must be coordinated with any traditional IRA contributions. For example, if a 30 year old single taxpayer making $50,000 of income in 2009 contributes $3,000 to a traditional IRA, the same taxpayer is limited to a $2,000 Roth IRA contribution for the same year.

Conversions

Some taxpayers may fund a Roth IRA by converting some or all of a traditional IRA to a Roth IRA. Conversion is accomplished by trustee-to-trustee transfer of the traditional IRA conversion amount to the Roth IRA trustee, or by 60-day rollover.

Since 2008, it is also possible for an eligible rollover distribution from a pension plan to be transferred, by direct or 60-day rollover, to a Roth IRA if the taxpayer otherwise qualifies for Roth conversion.

Upon conversion, the taxpayer will pay income taxes on the amount of converted pre-tax IRA money and any earnings thereon. A taxpayer who does a Roth conversion is not liable for the pre-59 ½ 10% penalty tax upon conversion.

In 2009, a taxpayer isn’t allowed to convert a traditional IRA to a Roth if modified adjusted gross income (excluding the amount converted) is above $100,000 in the calendar year of conversion. The same $100,000 limit applies to the overall income of couples filing jointly or single taxpayers. Individuals who are married filing separately aren't allowed to do a Roth conversion at all.

RMD Rules and Distributions on Death

Roth IRAs are not subject to the required minimum distribution rules during the lifetime of the owner; that is, an owner of a Roth IRA is not required to start taking payouts at age 70-1/2 as in the case of a traditional IRA. However, after the death of the account owner, the beneficiary must meet the same type of RMD requirements as for a traditional IRA.

Changes in 2010

Eligibility for Conversion

With the new rules that go into effect in January, 2010, taxpayers with incomes of more than $100,000 will be able to convert a traditional IRA into a Roth IRA.

Some taxpayers may have considered conversion in the past, but decided against it because their adjusted gross income was too high, or because they struggled with the income tax liability. The new rules will entice many to convert traditional IRAs to Roth IRAs in 2010.

Tax Deferral

As an added incentive for conversion in 2010, the taxpayer will also have the option to defer the federal income tax liability for the conversion.

If the deferral option is elected, the taxpayer will include 50% of the taxable conversion amount as income in 2011, and the other 50% in 2012. The taxpayer will pay federal income tax in those years based on the then-current tax brackets and income tax rates.

If conversion occurs after 2010, while the income limits on the ability to do conversion will no longer exist, the taxpayer will have to pay the entire income tax bill association with the transaction in the year of conversion.

Analyzing Whether Conversion Makes Sense

Factors

Conversion to a Roth IRA may make sense in the following situations:

1. The client expects the IRA account to grow substantially, and would prefer to pay taxes on the lower current account balance instead of on the expected large future amount.

2. The client expects that the post-retirement income tax bracket will be the same or higher than the current one.

3. The client expects to live for a long time after conversion, and does not want to have to take distributions from the IRA if they are not needed.

If the taxpayer is a candidate for conversion, it would also be important to evaluate whether there is enough non-IRA cash on hand to pay the tax associated with the conversion. If other assets have to be liquidated to pay the tax, the potential tax liability associated with liquidation would have to be factored into the conversion analysis.

Examples

The Client Expects the IRA to Grow

Say Melvin, age 40, is a successful physician with a traditional IRA balance of $100,000 on January 1, 2010. Assume also that the contributions and earnings are pre-tax, and that Melvin is in a 35% federal income tax bracket.

Melvin expects his IRA to grow at a rate of 7.2%, roughly doubling in value every ten years. When Melvin reaches age 70, assuming he makes no further contributions to the IRA, it may be worth about $800,000.

If Melvin keeps the account in a traditional IRA, all distributions from the account taken at that time will be taxable. If Melvin takes a lump sum distribution of $800,000 at age 70, if his tax bracket remains 35%, he will have to pay $280,000 in taxes.

On the other hand, if Melvin does a Roth conversion using the same assumptions, the $800,000 balance at age 70 will be available tax-free.

What is the cost for achieving that result? Melvin must be prepared to pay $35,000 out-of-pocket for the tax liability in 2010 associated with the conversion.

Does it make economic sense for Melvin to convert? Maybe. Here’s some simple analysis.

If Melvin keeps all the money in a traditional IRA and withdraws at age 70, he’ll net $520,000 based on the assumptions above.

If Melvin converts, he’ll net $800,000 at age 70. However, in the example, it cost him an extra $35,000 in out-of-pocket taxes today to get the $800,000 at age 70. If we do a future value calculation for the $35,000 expense using a 7.2% interest rate, we come up with $280,000. That means the net for Melvin at age 70 is $520,000 for conversion, as well.

Is it fair to assume a 7.2 % return for the $35,000 used to pay for the tax? Perhaps a lower rate is fairer, because $35,000 invested outside an IRA might be subject to income taxes. If we assume a lower interest rate for the future value analysis of the amount used to pay income taxes, it would make the conversion alternative look better than keeping the traditional IRA.

The Client Expects Tax Brackets to Be Bigger in the Future

If Melvin assumes that his own federal income tax rates in the future will be higher than today’s, it makes conversion look more attractive.

For example, assuming the tax rate at retirement is 50% instead of 35%, if Melvin keeps the traditional IRA, Melvin would only be able to keep $400,000 of an $800,000 lump sum distribution at age 70. However, since his 2010 tax bracket is assumed to be 35%, the income tax cost of conversion is still $35,000, and the value of the conversion option at age 70 is still $520,000. That increase in the assumed future tax bracket makes conversion look better.

The Client Wants to Defer RMDs

What if Melvin does not want to take any distributions at age 70? What if he plans to use other resources to support his retirement need?

If Melvin keeps the traditional IRA, he must begin taking required minimum distributions (RMDs) when he reaches age 70 ½--whether he needs them or not. When RMDs are taken, Melvin must pay income tax on them.

If Melvin converts to a Roth IRA, no RMDs are required from the Roth at any time during Melvin’s lifetime. The extra ability to defer distributions until after Melvin’s death—maintaining tax-deferred growth and tax-free access to the Roth IRA’s values—may tip his decision in favor of conversion.

Special Opportunity

The ability for high income taxpayers to convert from traditional to Roth IRAs in 2010 or later was clearly intended. There is another potential opportunity that is more hidden within the new rules.

Income Limit Eliminated for Roth Contributions

The new rules have created an opportunity for some taxpayers who may have wanted to contribute to a Roth IRA in the past, but whose high income did not permit them to make annual contributions.

Say we have a single taxpayer, age 52, making $500,000 of adjusted gross income in 2010. Under Roth IRA rules, the taxpayer is not eligible to make a regular Roth IRA contribution of $6,000.

However, the taxpayer is eligible to make a non-deductible traditional IRA contribution. There are no income limits for those types of contributions.

Say also that the taxpayer makes a $6,000 non-deductible contribution to a traditional IRA, which is the only IRA account the taxpayer has. The same taxpayer is eligible to do an immediate conversion of the IRA account to a Roth IRA. If the conversion occurs on the next day after the traditional IRA is funded, there is little or no taxable gain on the conversion amount. The taxpayer has effectively contributed $6,000 to a Roth IRA.

This opportunity may not be attractive if the taxpayer has substantial existing balances in traditional IRAs. If a taxpayer has one or more IRAs that consist of entirely pre-tax money, those all IRAs are consolidated for the purpose of calculating the taxpayer’s IRAs after-tax basis, as well as pre-tax contributions and earnings. Any conversion of a non-deductible IRA will be considered to be pro-rata from the taxable pot and the non-taxable portion.

Here’s an example. Say the 52 year old single taxpayer has a traditional IRA worth $94,000. The taxpayer makes a $6,000 contribution to a non-deductible IRA in 2010. The taxpayer converts the non-deductible IRA to a Roth IRA. Under those facts, the IRS considers that the conversion actually came from both accounts—not just the non-deductible IRA account. Based on the numbers in the example, only 6% of the conversion will be tax-free, and the other 94% will be taxable.

The hidden opportunity to do a Roth conversion from a non-deductible IRA works best for taxpayers that have no existing traditional IRA balances.

It is possible that the IRS may decide to attack the hidden strategy with rulings, regulations or court arguments. One such attack might be made using the step transaction doctrine. Under the step transaction doctrine, the IRS might treat the series of related steps as a single transaction. The tax result may be based on that transaction rather than the individual transactions in the series.

If step transaction doctrine is applied to non-deductible IRA conversion strategy, the attempted conversion may be treated as a surrender of the non-deductible IRA, and an excess contribution to the Roth IRA. Before recommending the non-deductible IRA conversion strategy, the professional advisor should discuss the potential risks with the client’s tax professional.

Conclusion

Roth IRAs are a valuable tool in helping a client plan for retirement. Roth accounts grow tax-deferred, and qualifying distributions are tax-free. A taxpayer can put off taking money out of the Roth account until death, maximizing the income tax-free transfer of wealth to family.

In the past, the biggest barriers to more widespread implementation of Roth IRAs have been

• The income-based restriction on contributions, and

• The income-based restriction on conversions of traditional IRAs to Roth IRAs.

Beginning in 2010, the income-based restrictions on conversions will be removed. Further, for some taxpayers, the ability to make contributions to a non-deductible IRA and subsequently convert to a Roth IRA will effectively remove the income-based restriction on contributions.

Clients will need special guidance to think through these and other retirement issues in 2010. Those financial professionals who are prepared with the right combination of information, financial alternatives and know-how will be in the best position to prosper.

Would You Like to Turn this Month’s Issue of Think About It Into a Dynamic Presentation for Your Next Company Meeting?

Tired of boring presentations at company meetings? Want to spice things up with a fun, interactive session focused on increasing results? Make the current issue of Think About It work for you and your producers!

Linas Sudzius, J.D., CLU, ChFC, one of the authors of Think About It, will show you how to use the information in the attached newsletter to make more money.

|[pic] |Linas is one of the principals of the ICS Law Group, PC. The ICS Law Group provides estate planning |

| |legal services to individuals, and non-litigation legal services to business owners. Its principal |

| |office is in Franklin, Tennessee. |

| | |

| |Linas worked for a Chicago-based insurance company as their Director of Advanced Sales and most recently |

| |as their Chief Marketing Officer. |

| | |

| |Linas also co-authors the publication Think About It with Steve Leimberg. |

Linas is now scheduling 90 minute and half-day presentations for early 2010. Contact Brenda Harvill at 615-224-1291 or brenda.harvill@ for availability and pricing information.

-----------------------

[pic]

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download