Tax-Free Income for You and Your Heirs: What You Need to Know About Roth Conversions Right Now. Bryan M. Totri, CFP

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1 Tax-Free Income for You and Your Heirs: What You Need to Know About Roth Conversions Right Now Bryan M. Totri, CFP 1

2 Saving for Retirement: Tax-deferred vs. Tax-free Traditional IRA Tax-deferred retirement plan Funded with pre-tax dollars Distributions are taxed as ordinary income Required minimum distributions start at 70-1/2 Roth IRA Funded with after-tax dollars Qualified distributions are tax free No required minimum distributions 2

3 What is a Roth Conversion? Converts a tax-deferred account to a taxfree Roth IRA Taxes are paid at the time of conversion Qualified distributions are tax-free No minimum distribution requirements 3

4 Which Accounts Are Eligible for Conversion? Traditional IRAs (both deductible and nondeductible) SEP IRAs SIMPLE IRAs (after 2 years) Distributions from qualified plans, including rollover-eligible 401(k) and 403(b) Inherited employer plans But NOT inherited IRAs 4

5 Why Convert to a Roth? Lock in today s tax rates Remove tax uncertainty on converted assets Achieve tax diversification in retirement Maintain a mix of taxable, tax-deferred, and tax-free accounts Maintain tax flexibility in retirement (no RMDs) Reduce or eliminate taxes on Social Security benefits Avoid higher Medicare Part B premiums Reduce or eliminate 3.8% Medicare surtax starting in 2013 Leave more to heirs Income stream to beneficiaries will be tax free 5

6 The Roth Conversion Conundrum Question: Is it worth it to pay taxes up front in exchange for tax-free income later? Answer: often it is - but the analysis requires you to make certain assumptions about the future 6

7 3 Questions to Ask 1. Will your future tax bracket be higher or lower than it is now? 2. Will you pay the conversion taxes with funds from inside or outside the IRA? 3. When do you plan to start taking distributions from your IRA and in what amount? 7

8 Roth Conversion Question #1 Will your future tax bracket be higher or lower than it is now? Higher bracket favors Roth Lower bracket favors traditional IRA 8

9 What is your tax rate today? Single Married filing jointly Head of household 10% $8,375 $16,750 $11,950 15% $34,000 $68,000 $45,550 25% $82,400 $137,300 $117,650 28% $171,850 $209,250 $190,550 33% $373,650 $373,650 $373,650 35% >$373,650 >$373,650 >$373,650 Based on taxable income, after deductions 9

10 Where do you think tax rates will go in the future? Current tax rates are at historical lows Higher budget deficits may lead to higher taxes Under current legislation, the top tax rate rises from 35% to 39.6% in 2011 Top tax rates If you think taxes will go up, consider converting to a Roth and paying taxes at today s tax rates 10

11 Roth Conversion Question #2 Will you pay conversion taxes with funds from inside or outside the IRA? Outside clearly favors Roth Inside may favor traditional IRA (but not always) 11

12 How much will conversion taxes be? Estimate taxes by multiplying taxable converted amount times your current tax bracket Example: $100,000 conversion at 28% tax bracket = $28,000 in tax Note: conversion may cause income to go into next tax bracket 12

13 What about after-tax contributions? After-tax (i.e., nondeductible) contributions may be converted to a Roth tax free Can t cherry-pick the after-tax portion Must aggregate all IRAs for the purpose of determining the taxable portion 13

14 When must conversion taxes be paid? Two options for paying conversion taxes Report all in 2010, pay at 2010 rates Report half in 2011, half in 2012, pay at then prevailing rates Taxes due on filing date: April 15 Estimated taxes may be required to avoid penalties: consult with tax advisor 14

15 Roth Conversion Question #3 When will you begin taking IRA distributions and in what amount? No choice with traditional IRA: Must take RMDs at 70-1/2 Roth more favorable if distributions are deferred past age 70-1/2 (draw from other resources first) Maximum benefit if Roth is passed to next generation 15

16 Distributions are Key to Roth Analysis Consider overall retirement income plan How much income will you need? Which accounts will you draw from first? Do you plan to pass assets to heirs? Consider effect of RMDs on traditional IRA: you may be forced to take larger distributions than you need To avoid having to take unwanted taxable RMDs, convert to Roth now 16

17 Examples of How Distributions Impact Roth Analysis Considers values over entire distribution period Assumptions for the following scenarios IRA holder is age 50 now IRA = $100,000 4% annual growth 28% tax bracket at time of conversion and during distribution period Roth conversion taxes paid from inside the IRA Life expectancy to age 95 Calculator shows values for: Scenario 1: Distributions start at 70 Scenario 2: Distributions start at 80 Scenario 3: No distributions during IRA holder s lifetime 17

18 18 Scenario 1: Distributions start at 70

19 Scenario 1: Distributions start at 70 Recommendation: No Roth conversion 19

20 20 Scenario 2: Distributions start at 80 RMDs from traditional IRA start at 70

21 Scenario 2: Distributions start at 80 RMDs from traditional IRA start at 70 Recommendation: Convert to Roth now 21

22 22 Scenario 3: Distributions start at 95 RMDs from traditional IRA start at 70

23 Scenario 3: Distributions start at 95 RMDs from traditional IRA start at 70 Recommendation: Convert to Roth now 23

24 Assumptions & Recommendations 24 Assumption Tax bracket in retirement will likely be higher than it is now Funds are available outside the IRA to pay conversion taxes Distributions will likely be later and smaller than RMDs Tax bracket in retirement will likely be lower than it is now Taxes paid with funds from inside the IRA Distributions will start in 5-10 years Convert to Roth now? Yes Yes Yes Maybe depends on distribution plans Maybe depends on distribution plans No, if under 59-1/2 (10% penalty on amount withdrawn for taxes) No

25 Case Study Mary, age 40 Current income $80,000 (28% tax bracket) IRA = $100,000 IRA annual growth rate: 4% No outside funds to pay conversion taxes Plans to retire at age 70 and immediately begin IRA withdrawals Projected future tax bracket: 25% 25

26 26 Roth Conversion Analysis for Mary

27 Roth Conversion Analysis for Mary Recommendation: No Roth Conversion 27

28 Case Study Michael, age 50 Current income $250,000 (33% tax bracket) IRA = $250,000 IRA annual growth rate: 4% Conversion taxes to be paid outside the IRA IRA distributions to start at 80 Projected future tax bracket: 28% 28

29 Roth Conversion Analysis for Michael 29

30 Roth Conversion Analysis for Michael Recommendation: Convert to a Roth now 30

31 Case Study Robert, age 60 Current income $80,000 (25% tax bracket) IRA = $500,000 IRA annual growth rate: 4% Conversion taxes to be paid outside IRA Plans to start IRA distributions at 75 Projected future tax bracket: 28% 31

32 Roth Conversion Analysis for Robert 32

33 Roth Conversion Analysis for Robert Recommendation: Convert to a Roth now 33

34 Case Study Kathleen, age 70 Current income $60,000 (25% tax bracket) IRA = $1,000,000 IRA annual growth rate: 4% Conversion taxes to be paid outside IRA IRA distributions to start at 85 Projected future tax bracket: 28% 34

35 Roth Conversion Analysis for Kathleen 35

36 Roth Conversion Analysis for Kathleen Recommendation: Convert to a Roth now 36

37 Roth Details You Should Know You do not have to convert your entire IRA: partial conversions are OK You can do a series of conversions over several years If a portion of your IRA consists of after-tax contributions, they are not taxed upon conversion (caveat: can t cherrypick the after-tax amount; must aggregate all IRAs to determine basis) If you change your mind before your extended filing date (October 17, 2011 for 2010 conversions), you can recharacterize your Roth back to a traditional IRA 37

38 What Do You Need To Make the Roth Conversion Decision? Consider overall retirement income plan Social Security Pensions Withdrawals from IRAs and investment accounts Consider availability of funds to pay conversion taxes Consider current and future tax brackets Meet with advisors to discuss and analyze 38

39 Planning Your Roth Conversion Perform conversion analysis full service clients will be provided a review Discuss with advisors: Which accounts may be converted How much to convert When to convert How to convert Pitfalls to avoid 39

40 What Do You Stand to Gain from a Roth Conversion? Freedom from higher tax rates on converted assets More withdrawal flexibility for greater tax management in retirement More after-tax income for yourself and/or your beneficiary 40

41 Thank You! This material does not constitute tax, legal or accounting advice. Please consult your professional advisors for advice relating to your specific situation. A Roth IRA distribution is qualified if you ve opened and funded the account for at least five years and the distribution is made after you ve reached age 59 1/2. Distributions made prior to age 59 1/2 may be subject to a federal income tax penalty. 41

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