QUARTERLY NOTE September, 1998

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1 QUARTERLY NOTE September, 1998 ROTH IRA CONVERSIONS So What is the Big Deal about Roth IRA Accounts? Roth IRA accounts are a new and potentially tremendous vehicle for accumulating family wealth. Funds within a Roth IRA compound tax-free over the years and then have the following benefits over ordinary IRAs: Funds are withdrawn from a Roth IRA completely tax free after a five-year waiting period if one of the following conditions is also true: a.) The owner has attained age 59 ½, b.) The funds (up to a lifetime limit of $10,000) are used by a first-time buyer to acquire a principal residence c.) The withdrawal is made because the owner is disabled, OR d.) Withdrawals are made to a beneficiary after the taxpayer's death. In contrast, funds withdrawn from an ordinary IRA are taxed at ordinary tax rates, (to the extent they do not represent a return of after-tax contributions). There are no mandatory distribution requirements for Roth IRAs during the owner's lifetime. In contrast, owners of ordinary IRA accounts are subject to mandatory, taxable with-drawals according to IRS-determined guidelines each year once the owner turns 70 ½. And finally, persons who inherit Roth IRAs can stretch out withdrawals over five years or their own life expectancy, whichever they choose, regardless of the age of the owner at the time of death. In contrast, non-spouses who inherit ordinary IRAs from someone over the age of 70 ½ might be forced to withdraw all funds by the December 31st of the year following the death of the owner. Regulations require that the life expectancy calculations for ordinary IRAs become irrevocable at the owner's age 70 ½. How Do I Get Money into a Roth IRA?

2 The tax-sheltering provided by these three factors make the Roth IRA a powerful vehicle for the accumulation of family wealth - so valuable, in fact, that the government limits how Roth IRAs are funded. According to regulations, Roth IRAs can be funded either by new deposits or by converting funds held in an ordinary IRA account. New deposits into all IRAs are limited each year to the lower of earned income or $2,000. Contributions into Roth IRAs can only be made by married taxpayers whose adjusted gross income is less than $150,000 and single taxpayers whose AGI is less than $95,000. For amounts that are converted, there is no upper limit on the dollar amount but the owner must be eligible to convert by having adjusted gross income (excluding the converted amount) equal to $100,000 or less. (NOTE: Starting in 2005, mandatory distributions from ordinary IRA accounts will also be excluded from this definition of adjusted gross income.) The big restriction on converting ordinary IRA funds to a Roth IRA is that income taxes become immediately due on the converted funds to the extent the converted funds have not already been taxed. The taxable amount is taxed as ordinary income in the year of conversion - except that taxpayers who convert in 1998 can choose to spread out the income (not the tax!) over four years. Advisors generally suggest that conversions do not make sense unless these taxes can be paid with funds outside of the IRA. PLANNING TIP: If you are about to retire and you have an ordinary IRA account funded with both deductible and non-deductible contributions, and you want to convert some or all of the IRA, consider postponing the rollover of qualified plan funds until the year after you convert ordinary IRA funds into a Roth IRA. (As funds are converted, the portion that is excluded from income taxation is the fraction of total non-deductible contributions made to all IRAs to the year-end total value of all IRAs, regardless of whether accounts have been commingled.) You are a Candidate for a Roth IRA Conversion if: You already have funds stored in an ordinary IRA account; You are aware that Roth IRAs are great vehicles for wealth accumulation; Your Adjusted Gross Income, not counting funds to be converted, is less than $100,000; You have sufficient non-ira funds to pay the taxes; AND You believe that the decision to pay taxes early will be rewarded with a substantial future tax benefit. But Who Would Want to Convert to a Roth IRA? In general, conversions make sense if you are willing and able to pay taxes now in the hope of capturing a potential tax benefit at a later date. The trade-off is obviously affected

3 by many factors, including your tax bracket at the time of conversion and the tax bracket applicable when funds are withdrawn. It also matters how long and how fast the funds will grow between conversion and withdrawal. And finally, estate tax considerations can also drive a decision to convert, including for example, a desire to avoid funding a credit shelter trust with highly taxable ordinary IRA funds. The interaction of these multiple factors cries out for sophisticated modeling. But there is also a role for common sense: Most young persons, for example, are prime candidates for a Roth conversion. Most people under the age of about 25 have relatively small ordinary IRA accounts and are in a relatively low tax bracket. Young owners also have a long time to let a Roth account grow and may well be in a high tax bracket at the time of withdrawal later on in life. Conversions for these taxpayers will often make sense, since the cost of conversion is low and the future benefit, with good probability, is high. Secondly, IRA owners who are sick and/or who need custodial care at the end of their lives are also prime candidates for a Roth conversion, especially if they have a taxable estate. In this case, medical expense deductions may reduce taxable income to the point where the additional tax created by a Roth conversion will not be burdensome-and to the extent present those taxes might also reduce the taxable estate. These end-of-life conversions are also particularly appropriate when heirs are in a high tax bracket and/or would benefit from the Roth IRA rules allowing nonspouse heirs to stretch withdrawals over their lifetimes (for example, high tax-bracket children of parents who have chosen a non-optimal calculation method for mandatory IRA withdrawals). Conversions in between these two examples provide more room for debate. In general, even healthy owners who convert after the age of about 60 are unlikely to reap substantial tax benefits during their lifetimes. Thus, older IRA owners who decide to convert are demonstrating a clear desire to create wealth for heirs. They are also demonstrating good confidence that their own wealth, net of the taxes triggered by conversion, will be sufficient for their lifetime needs. Owners younger than about age 60 have a chance of reaping some benefits for themselves-if the multiple variables roll out favorably - and so they may be acting both for themselves as well as for heirs. For owners caught in this middle ground, personal goals are thus critically important to the decision of whether or not to convert. Especially for these middle-ground owners, the method of analysis will largely determine the resulting recommendation. For example, depending on your inclination, you can make an elaborate financial model print out your desired result by choosing particular assumptions about the time horizon, investment return, and tax rates. If you are willing to rely on such assumptions, it is fairly easy to create support for a recommendation to

4 convert substantially all of a taxpayer's IRA. But many taxpayers, when faced with a recommendation to convert - even if the analysis is based on very reasonable assumptions - fall back on the time-honored notion that it is probably foolish to pay taxes early in order to capture a possible future tax benefit. Is there a middle ground between believing a financial forecast and refusing to pay any taxes early despite it being a potentially profitable idea? Yes, of course there is, if you incorporate the decision to convert with other tax planning considerations each year and so over time build a Roth IRA account through a series of gradual, modest conversions. In this light, older couples in which one spouse has a large IRA and one spouse a small IRA may convert the smaller IRA. The tax cost of such a conversion is relatively low and the conversion would end the annual mandatory distribution hassle for one spouse. Taxpayers making charitable contributions will look for ways to match high-contribution years with high-conversion years. Similarly, taxpayers with substantial portfolios will seek to match investment losses with conversion years and to avoid conversion in years with high investment gains. Other taxpayers will ask their accountant how much they can convert each year without moving into a higher tax bracket or boosting taxes by more than some specified dollar amount, or triggering increased taxation on Social Security income or a phase-out of itemized deductions or allowances. By looking for a series of small, relatively inexpensive opportunities to convert, IRA owners increase their chances of having a conversion that looks good in retrospect, not just on today's paper reports. They will also gradually diversify tax strategies. With wealth stored in many accounts, with a variety of tax characteristics, these IRA owners will be ready for unexpected change - the one part of the future we know is coming. As with most financial planning challenges, the most appropriate strategy may be modest, gradual steps made in coordination with personal preferences and the total financial picture. The Mechanics of Converting to a Roth IRA Conversion to a Roth IRA involves completing a form with your current custodian. It is not hard to do, but it must be done by year-end. If you don't know whether your income will come in under the income limits, convert by year-end anyway and then unconvert or, to use the modern term, re-characterize the converted amount, if necessary by filing another form with the custodian(s) by the due date of the tax return, usually April 15th of the following year. (The IRS requires that very specific information be forwarded to the custodian of the converted and of the re-characterized IRA.) Did you convert when the market was high? Some commentators think you can recharacterize during the year, convert again by year-end, and so lower taxes. Be careful though - custodians may not be cooperative and the strategy is not yet widely tested.

5 Paula H. Hogan, CFP, CFA Copyright 1998 ;1998 Hogan Financial Management. All Rights Reserved.

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