Roth IRA Conversions Planning for New Opportunities

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1 C ANDY J. LEE Financial Planning & Money Management Roth IRA Conversions Planning for New Opportunities Roth IRAs allow you to grow your assets, take withdrawals, and pass assets to your heirs tax-free*. Sounds great! So great that up until now the IRS imposed significant limitations on who could contribute and convert their IRA(s) to a Roth. In 2010 the $100,000 Modified Adjusted Gross Income (MAGI) limit for converting your IRA to a Roth will be repealed. Depending on your current and projected income, this could have significant advantages for reducing your taxes in the future. The taxes you pay on the dollar amount you convert from your Traditional IRA to the Roth are the last taxes you or your heirs have to pay on that money. There is also a special income recognition rule in 2010 that allows you to postpone half your tax payment for any 2010 conversion to your 2011 tax year and the other half in You could actually postpone paying half the conversion income tax up to 34 months and up to 46 months for the second half. High-income individuals that can pay the taxes out of non-ira savings and also anticipate high income in retirement have the most to gain. Individuals that are unable to pay the taxes from non-ira assets or anticipate a low tax rate in retirement have the least to benefit. The following is a summary of the features and rules of Roth IRA: conversions, recharacterizations, important dates and strategies. *In this text tax-free is defined as income tax-free. Roth IRAs may be subject to estate and other applicable taxes. Current Roth IRA Rules There are three ways to fund a Roth IRA: you can contribute directly to a Roth, rollover eligible distributions from an employer retirement plan, or convert all or part of a Traditional IRA to a Roth IRA. Who Can Contribute? Under the rules outlined by the Taxpayer Relief Act of 1997 the federal government imposed strict income limitations on who can contribute to a Roth IRA. Your ability to contribute to a Roth IRA depends on your modified adjusted gross income as presented in the chart below: IF you have taxable compensation and your filing status is married filing jointly or qualified widow(er) married filing separately and you lived with your spouse at any time during the year single, head of household, or married filing separately and you did not live with your spouse at any time during the year You can contribute the maximum allowed amount if your modified AGI is less than $166,000 your modified AGI is zero (0) your modified AGI is less than $105,000 You are subject to contribution phaseouts when your modified AGI is greater than $166,000 and less than $176,000 your modified AGI is greater than zero (0) and less than $10,000 your modified AGI is greater than $105,000 and less than $120,000 To arrive at your modified AGI, start with your AGI, subtract any income from Roth conversions, required minimum distributions, and then add back the following items: Colombia Center 701 Fifth Avenue Suite 6870 Seattle, WA (206) Investments and advice offered through Financial Services International Corp. fsic (206)

2 Any deductions you claimed for a regular (nonrollover) contribution to a traditional IRA. Any deduction you claim for interest on education loans or for qualified tuition and related expenses. Any income you excluded because of the foreign earned income exclusion. Any exclusions or deductions you claim for foreign housing. Any interest income from series EE bonds that you were able to exclude because you paid qualified higher education expenses. Any amount you excluded as employer-paid adoption expense. Any amount claimed as a domestic production activities deduction. Note that although you add back contributions to a traditional IRA, you are not required to add back any contributions you made to an employer plan such as a 401(k) plan. Income from Roth IRA conversions is not included in modified AGI, so a conversion will not interfere with your ability to make regular contributions. Unlike a Traditional IRA that disallows contributions after the age 70 ½, you can contribute to a Roth IRA as long as you have taxable income. How Much Can You Contribute? In general, Roth IRA contributions are limited to the lesser of taxable compensation or $5,000 ($6,000 if you are age 50 or older). If your modified AGI is above a certain threshold your Roth IRA contributions are subject to gradual reduction. To calculate your allowed Roth IRA contribution use Worksheet 2-2 of IRS publication 590. For married couples filing jointly spousal Roth IRA contributions can be made. The spouse that makes less can contribute the lesser of $5,000 ($6,000 if you are age 50 or older) or the total compensation included in the gross income for both you and your spouse less your spouses Traditional IRA and Roth IRA contributions. This means that couples under the age of 50 can contribute up to a maximum of $10,000 for the year ($11,000 if only one spouse is under the age of 50 and $12,000 if both of you are age 50 or older). If you contribute to a Traditional IRA in the same year as a Roth, the sum of all contributions cannot exceed the maximum allowed contribution. Who Can Convert to a Roth IRA? To convert all or part of a Traditional IRA to a Roth IRA in 2009 you must have a modified AGI of less than $100,000 and you are not filing as married filing separately. How Much Can I Convert? If your modified AGI is less than $100,000 you can convert all or part of your Traditional IRA to a Roth IRA. Can I Rollover my Employer Retirement Plan to a Roth IRA? Prior to 2008 you could only rollover (convert) a Traditional, SEP or SIMPLE IRA into a Roth IRA. This rule has been changed and starting in 2008 you can rollover all or part of an eligible rollover distribution you receive from your (or your deceased spouse s): Employer s qualified pension, profit-sharing or stock bonus plan (includes 401(k) plans) Annuity Plan Tax-sheltered annuity plan (section 403(b) plans) Governmental deferred compensation plan (section 457 plan) History of the Roth IRA The Roth IRA was introduced in 1998 as a new retirement vehicle that provided savers with a tax-free alternative for growing wealth. Unlike the Traditional IRA, which provides tax-deferred growth, the Roth IRA allows you to contribute after tax dollars that can grow and be distributed tax-free for the rest of your lifetime. In 2005 required minimum distributions (RMDs) were no longer counted as part of modified AGI for Page 2 of 12

3 Roth IRA conversion calculations. Prior to 2005 people whose RMDs increased their modified AGI above $100,000 were disallowed from converting to a Roth IRA. The 2005 change allows these individuals that were previously disallowed from converting to a Roth IRA to do so. More changes were enacted in 2006 when Roth accounts were authorized for 401(k) and 403(b) employer pension plan. Also, modified AGI limits for contributions were indexed for inflation. Eligible distributions from employer pension plans were allowed to be rolled-over into Roth IRAs in What s New for 2010? In 2010 high income individuals will have the opportunity to convert all or part of their Traditional IRAs and rollover eligible employer pension distributions to Roth IRAs. These changes are due to the Tax Increase Prevention and Reconciliation Act (TIPRA) signed into law in 2006 by George W. Bush. TIPRA repeals the modified adjusted gross income limitation currently used for Roth IRA conversions. Beginning on December 31 st 2009, TIPRA repeals the modified AGI limitations for Roth IRA conversions allowing all individuals the ability to convert Traditional IRA and eligible employer retirement plans to Roth IRAs. Also, as a part of TIPRA, the tax burden incurred from converting to a Roth IRA in 2010 can be spread 50/50 across the 2011 and 2012 tax years. This option is actually the default. If you want to pay all of the taxes in 2010 you will have to indicate this on your 2010 taxes. Roth IRA Conversion Changes in 2010 if you are single, head of household or married filing jointly 2009 $100,000 modified AGI limitation your tax incurred from the conversion will be paid in tax year no modified AGI limitation Why Contribute or Convert to a Roth? 50% in tax year 2011 and 50% in tax year 2012 unless you opt to pay it all in 2010 Why Should I use a Roth IRA as a Retirement vehicle? To begin, let s review some rote facts about Roth IRAs: You can contribute to a Roth IRA at any age as long as you have taxable compensation. There are no minimum distribution requirements. Roth IRAs have no age requirement for starting withdrawals. Qualified distributions from your Roth IRA are not included in taxable income therefore distributions will not increase the portion of your social security subject to tax. Distributions to your heirs are income taxfree. Income taxes are near a 50-year low and there is an increasing government deficit, which makes it more likely that tax rates will be higher in the future. The most compelling reason to use a Roth IRA is that Roth IRAs grow tax-free. In a simple world, funding a Roth IRA or a Traditional IRA yields the same result. For example, assume you contribute $5,000 to both a Roth IRA and a Traditional IRA. In this simple world your current and retirement tax rates stay constant at twenty-five percent (25%). The effective amount that goes into the Roth is $3,750 after a 25% tax of ($5000*.25 = $1250), and $5,000 is contributed to the Traditional Account tax-deferred. The accounts both grow at the same rate to three hundred percent (300%) of your original contribution, and at this point you distribute both accounts. The Roth IRA distribution is tax-free and you receive $11,250. The Traditional IRA on the other hand is taxed, ($15,000 - $15,000*.25 = $11,250). You receive exactly the same amount from both accounts. Page 3 of 12

4 Roth IRA Traditional IRA brackets and individuals who intend on working in retirement have the most to gain from a Roth IRA. Initial Contribution $5,000 $5,000 Tax on contribution 25.00% 0.00% Contribution Net of Taxes $3, $5,000 Growth rate % % Value at Distribution $11, $15, Tax on distribution 0.00% 25.00% Distributed to you $11, $11, As a second Example, let s see what happens if you pay the Roth IRA taxes from non-contributory cash funds. Tax on contribution Roth IRA $1, paid from noncontributory funds Traditional IRA $0.00 Initial Contribution $5,000 $5,000 Growth rate % % Value at Distribution Tax on distribution Distributed to you $15, $15, $0.00 $3,750 $15, $11, Total Net of taxes $13, $11, As you can see by paying the Roth IRA taxes from non-contributory cash funds the Roth IRA will create approximately 22% more wealth in retirement. Who Benefits Most from a Roth? Roth IRAs are more attractive the longer they have to grow. As a general rule, younger people in low tax People nearing retirement should consider a Traditional IRA if they expect their tax rate to be significantly lower in retirement than in the years they contribute or convert. The following chart shows the amount you need in a Traditional IRA account for every one hundred dollars in a Roth IRA, using today s federal income tax rates. Tax Bracket Benefit 10% $ % $ % $ % $ % $ % $ *Benefit is $100 divided by 1 minus the tax bracket. (Thomas, 27) As you can see saving in a Roth favors those who are in a higher tax bracket in retirement. If you are in the 35% tax bracket saving in a Roth can make you as much as 53% wealthier in retirement. To build a framework for you to base your Roth IRA conversion decision on, let s take a look at a couple of situations that may arise due to changing tax rates throughout your lifetime. In the previous examples we made the assumption that your tax rate will be the same in current years and in retirement. This is obviously an oversimplification of reality so let s loosen this assumption a bit and take a look at what happens. For the purpose of the following examples we made the following assumptions: initial contribution = $5,000, growth rate = 300%, taxes are paid from funds inside of the Roth IRA, and funds will be taken out of the accounts in a one time distribution. Example 1: This example analyzes the affect of higher taxes in retirement. For the purpose of this example your current marginal tax rate is 25% and your tax rate in retirement will be 33%. Page 4 of 12

5 Roth IRA Traditional IRA Tax Rate on Contribution 25% 0% Tax on Contribution $1, Initial Contribution $3, $5, Growth Rate 300% 300% Value at Distribution $11, $15, Tax Rate on Distribution 0% 33% Distributed to you $11, $10, Total Net of Taxes $11, $10, As the previous chart shows this example favors the Roth IRA. The Roth creates 12% more wealth in retirement. In the second example we examine the opposite scenario. The current marginal tax rate is 33% and the retirement tax rate is 25%. This scenario of higher current tax rates and lower retirement tax rates favors the Traditional IRA. Roth IRA Traditional IRA Tax Rate on Contribution 33% 0% Tax on Contribution $1, Initial Contribution $3, $5, Growth Rate 300% 300% Value at Distribution $10, $15, Tax Rate on Distribution 0% 25% Distributed to you $10, $11, Total Net of Taxes $10, $11, Taxes Social Security taxation effect: Social security income is taxed up to 85% if your income exceeds a certain threshold. Taxable RMDs from a Traditional IRA may significantly increase your social security taxes. Distributions from a Roth are not added to income so they do not increase taxes on social security. This is a hidden benefit of a Roth. Estate Taxes: When you die, your beneficiaries will pay no income tax on proceeds: As long as any Roth IRA you have established has been in existence for at least five years at the time of your death, your beneficiaries will not have to pay any federal income tax on postdeath distributions from any Roth IRA you own. Even if you haven't satisfied the five-year holding period at the time of your death, distributions to your beneficiaries will still be tax free if he or she does not distribute until the date you would have satisfied the five-year holding period before taking distributions from the Roth IRA. Income tax-free distributions to your beneficiaries can make the Roth IRA a very valuable estate planning option. However, bear in mind that the value of your Roth IRA will be included in your taxable estate to determine if federal estate tax is due. Caution: The five-year holding period applies independently to Roth IRAs you hold as a beneficiary, and Roth IRAs you hold as your own. If your sole beneficiary is your surviving spouse, and your spouse treats your Roth IRA as his or her own when you die, distributions from the Roth IRA will be tax-free only if your spouse satisfies the requirements for a qualified distribution (that is, your spouse satisfies the five-year holding period, and the distribution is made after your spouse attains age 59½, becomes disabled, dies, or incurs qualifying first-time homebuyer expenses). The five-year holding period for both the inherited IRA and any other Roth IRAs your spouse may own ends on the earlier of (a) the end of your five-year holding period, or (b) the end of the five-year holding period applicable to your spouse's own Roth IRAs. Page 5 of 12

6 When you die, the assets in your Roth IRA are considered when determining if estate tax is due: Unless you name your spouse as beneficiary (unlimited marital deduction) or a charity as beneficiary (charitable deduction), the full value of your Roth IRA at the time of your death is included in your taxable estate to determine if federal estate tax is due. In addition, the state you reside in may impose a state death tax. Potential New Tax: Congress in the past has found creative ways to renege on the promises of tax-free income. For example, tax laws changed making the calculation of how much of your social security is taxable, by requiring retirees to add in their otherwise untaxed municipal bond interest. There is always the possibility our government could impose an indirect method of collecting taxes by counting anything you take from the Roth for the purpose of deciding whether you are eligible for other tax breaks. Estimated Tax Payments: The safe-harbor rule for estimated taxes applies in this case. The tax due on the conversion won't be due until 4/15 and any penalty will be avoided as long as ES payments for the year equal 100% of the prior year's tax, or for higher income with AGI greater than $150,000, 110% of the prior year's tax. Contribution Guidelines After-tax dollars are contributed to Roth IRAs; the maximum contribution for 2009 is $5,000 ($6,000 if you are 50 or older). These contribution limits are subject to modified AGI limitations, as described in the following chart: Roth Contribution Reductions Based on 2009 Modified Adjusted Gross Income (MAGI): If you are subject to contribution phase-outs the amount is rounded up to the nearest $10. The lowest IRS recognizable amount is $200 prior to 100% phase-out. Employer Contribution Plans also known as Salary Deduction Plans: Salary deduction plans versus contributory IRAs: Salary deduction plans such as a 401(k), 403(b), SEP IRA or SIMPLE Plans have higher limits than a nonsalary deduction retirement plan such as an IRA and a Roth. Both salary deduction plans and IRAs have contribution limits based upon the aggregate of all contributions to any salary deduction plan or IRA. Roth 401(k), 457(b), 403(b) and SAR-SEP plans contribution limits are the same as the traditional employer plan limits. You can choose the traditional method or Roth but not to exceed the maximum for both of $16,500 plus $5,500 catch up for over age 50 for SIMPLE Plan limits $11,500 plus a $2,500 catch up in SEP IRAs can accept additional IRA contributions into the plan as long as you do not violate the aggregate rules for other IRA nonpayroll deduction type contributions. An individual Roth cannot start the five-year distribution clock for your contributions into a Roth 401(k) or 403(b). Each Roth 401(k) or 403(b) has their own 5-year requirement if distributed directly from an employers plan. If you roll that money into an existing Roth IRA that money has to satisfy its own 5-year rule. You can transfer the five-year aging if you transfer to another employer plan using a trusteeto- trustee transfer, but not if you do a rollover to another plan. Distribution Guidelines Qualified Distributions Distributions from your Roth IRA are qualified (completely income tax-free) if they are made at least Page 6 of 12

7 5-years after you first established any Roth IRA, based on January 1 st of the first year you make a contribution, and one of the following also applies: Made on or after the date you reach age 59 ½ Made due to death or disability, or The distribution is made for first-time homebuyer expenses ($10,000 lifetime limit). For example, in October of 2006 you open and contribute to a Roth IRA. In June 2007 you open another Roth. For the purpose of the five-year test your five-year period begins on January 1 st 2006 and you will have satisfied this requirement on January 1 st of If you inherit a spousal Roth IRA you have the option to treat the account as part of your Roth IRA. If you treat the account as your own your Roth IRA will inherit the earliest start date of both Roths. What Happens if I Inherit a Beneficiary Roth IRA? If you inherit a beneficiary Roth IRA you cannot include it in your own Roth IRA. There are two rules that govern distributions from a Roth IRA. Rule 1: The entire Roth IRA must be distributed by the end of the fifth calendar year after the year of the owner s death, or Rule 2: Sequential payments must be made to a designated beneficiary over the life or life expectancy of the designated beneficiary. Non-qualified Distributions If a non-qualified withdrawal is taken from a Roth IRA the investment gain portion of an early distribution may be subject to federal income tax and a 10% additional tax. Distributions are ordered as follows: 1) Regular contributions 2) Conversion and rollover contributions a. Taxable portion (the amount required to be included in gross income because of the conversion or rollover) first, and then the b. Nontaxable portion. 3) Earnings on contributions This chart was taken from IRS publication (IRS, 68). Conversions into a Roth IRA must satisfy their own five-year period. On February 28 th 2007 you convert half of your Traditional IRA to a Roth IRA. Then on July 15 th 2008 you convert the other half of your Traditional IRA to a Roth. The first conversion s five-year period ends January 1 st 2012 and the second conversion s five-year period ends on January 1 st What Happens if I Inherit a Spousal Roth IRA? Exceptions to 10% additional tax: You have reached 59 ½. You are disabled. You are the beneficiary of a deceased IRA owner. You use the distribution to pay certain qualified first-time homebuyer amounts. The distributions are part of a series of substantially equal payments. You have significant unreimbursed medical expenses. You are paying medical insurance premiums after losing your job. The distributions are not more than your Page 7 of 12

8 qualified higher education expenses. The distribution is due to an IRS levy of the qualified plan. The distribution is a qualified reservist distribution. The distribution is a qualified disaster recovery assistance distribution. The distribution is a qualified recovery assistance distribution. *note: These exemptions do not exempt you from meeting the requirements of the five-year test. Although the distribution rules can be somewhat complex if you take a distribution from a Roth IRA and it is comprised solely of contribution money the distribution is income tax and penalty free. Distributions of contributed dollars are always income tax-free and penalty free no matter if the distribution is qualified or not. When taking an early withdrawal, your contributed money comes out first before conversion dollars and earnings on contributions. Thus, the distribution is not included in taxable compensation and there are no penalties as long as you do not exceed the dollar amount of the sum of all contributions. For example, on September 15 th 2007 you convert all of your $50,000 Traditional IRA to your Roth IRA which you have contributed $15,000 to in the past. On February 13 th 2008 you distribute $20,000 from your Roth IRA. The first $15,000 represents the dollars you contributed to the Roth hence it is distributed tax and penalty free. The next $5,000 is distributed tax free because your Traditional IRA conversion was included as 2007 taxable compensation. Keep a running tally of your total contributions over the years in order to prove the distributions are not taxable. The IRS will match this information against the reports they receive. Distribution from Roth 401(k) and 403(b) Plans Unlike a Roth IRA where withdrawals are ordered, funds are distributed from Roth 401(k) and 403(b) plans as part contribution part earnings. Minimum distributions are required for Roth accounts in employer plans. You can bypass these minimum distributions by rolling your qualified distributions into a Roth IRA. Converting a Traditional IRA to a Roth IRA There are three methods for converting amounts from a Traditional IRA to a Roth IRA: Rollover You can receive a distribution from a Traditional IRA and roll it over to a Roth IRA within 60 days after the distribution. Trustee-to-trustee transfer You can direct your current trustee to transfer an amount from your Traditional IRA to the trustee of the Roth IRA. Same trustee transfer If your current trustee maintains Roth IRAs you can direct them to transfer an amount from your Traditional IRA to the Roth IRA. Can I Convert from my Employer s Plan? You are not allowed to convert your 401(k) or 403(b) Traditional accounts to a Roth 401(k) or 403(b) account, but as of 2008 you can roll any distribution from a 401(k) or 403(b) into a Roth IRA as long as it is eligible to be contributed into an IRA. Conversion Limitations 2009 Rules: In 2009 to be eligible to convert a Traditional IRA to a Roth IRA your modified AGI must be less than $100,000. If your modified AGI is greater than $100,000 you cannot convert to a Roth IRA. If your modified AGI is under $100,000 in 2009 there is no limitation on how much you can convert to a Roth IRA. If you are close to the modified AGI Page 8 of 12

9 limitation you should consider converting; you can always recharacterize at a later time and beyond In 2010 the modified AGI limitations will be repealed. If your income previously excluded you from converting to a Roth IRA, you can now convert. Paying Taxes on Conversions In 2009, in general, conversion from a Traditional IRA should be included in 2009 taxable compensation. In most cases the amount taxable is the same as the amount converted. If you take advantage of the 2010 loosening of the conversion rules there is a special income recognition rule for 2010 that allows you to report half of the conversion on your 2011 tax return and the other half on your 2012 tax return. Splitting the taxes between 2011 and 2012 is the default so if you would like to pay taxes on the converted amount in 2010 you must elect to do so when you file your 2010 taxes. If you convert to a Roth in 2010 and then distribute converted money in the same year, you will have to pay income tax on the distribution in the 2010 tax year and reduced tax in For example, you convert $20,000 to a Roth IRA and then take a 2010 distribution of $7,000 from your Roth IRA. You will pay tax on $7,000 in 2010 and tax on $10,000 in 2011 and $3,000 in Taxes on Non-Deductible Traditional IRA Contributions When you convert a Traditional IRA that has basis (amount of non-deductible contributions less basis recovered in connection with other previous distributions) all of the conversion amount may not be taxable. Basis is aggregated across all of your IRAs and then taken out as a fraction of your total IRA amount. For example, assume you have a Traditional IRA worth $20,000 with a basis of $5,000. If you convert $10,000 to a Roth IRA $7,500 of the conversion will be taxable and $2,500 will be non-taxable. The basis represent 25% of the Traditional IRA value ($5,000 / $20,000 = 25%) and 25% of $10,000 is $2,500. Therefore, $2,500 of the conversion is considered basis and the other $7,500 is taxable. If you have multiple Traditional IRAs all accounts are treated as one. Assume you have two IRAs worth $20,000 each with a total basis of $5,000. If you convert the same $10,000 amount $8,750 will taxable and $1,250 will be non-taxable. Things to Consider Before Converting Inherited IRAs cannot be converted to a Roth IRA. Traditional IRA required minimum distributions must be taken prior to converting your Traditional IRA. If you do the conversion and then take the RMD you have a failed conversion. You cannot convert a recharacterized Traditional IRA until next year or thirty days, whichever is later. The IRS only allows one rollover in a 12 month time period. There is an exception that allows you to rollover funds from one Traditional IRA to another Traditional IRA and then rollover the same funds into a Roth IRA. However, if you want to recharacterize the Roth IRA to a Traditional IRA you cannot do so. In general, whenever possible it is best to use a conversion method rather than a 60-day rollover. You can convert a Traditional IRA after starting to take periodic payments. After conversion to a Roth IRA you must continue to take periodic payments or else all periodic payments previously taken may be subject to penalties. Recharacterizions A recharacterization allows you to reverse a conversion or deposit into a Roth IRA. It was designed to reverse a mistake such as an ineligible contribution, but can be used to your advantage to Page 9 of 12

10 reduce the amount of taxes you pay in a conversion. Once done you cannot reverse a recharacterization. You can use a recharacterization to change the direction of your IRA or Roth contribution during the same tax year. You cannot redirect employer contributions. If you used a recharacterization to undo a conversion into a Roth IRA you cannot convert the same amount into a Roth IRA until the next year or 30 days, whichever is later. For example, in February 2008 you converted your Traditional IRA to a Roth. In October of the same year you received a large bonus at work that will cause your modified AGI to exceed the $100,000 limit; hence you are disqualified from converting to a Roth IRA. You recharacterize the Roth IRA conversion. You cannot attempt another Roth IRA conversion on the same money until January 1 st of Recharacterizing a specific amount does not disqualify you from converting other amounts. Assume you convert and then recharacterize half of your Traditional IRA. During the same year you can convert the half of your Traditional IRA that you did not previously convert. You can specify which conversion you want to recharacterize. For example, you convert half of your Traditional IRA to your Roth IRA in January and then you convert the other half in July. The January conversion, which consists of international equities, has appreciated substantially whereas your July conversion was in U.S. bank stocks and has declined in value significantly. In this scenario you could recharacterize the July conversion and leave the January conversion. You can recharacterize a conversion up until October 15 th of the year following the conversion. Make sure that the trustee for your Roth IRA and Traditional IRA complete the recharacterization before the deadline. Important Dates and Timeframes General Roth Deadlines Contributions can be made to a Roth IRA from January 1 st of contributing year to April 15 th of the following year for most. Conversion from a Traditional IRA account must leave the Traditional IRA by December 31 st of the conversion year. Recharacterizations must be done by April 15 th, or October 15 th with extension, of the year following the conversion being recharacterized. The five-year Roth IRA holding period begins as of January 1 st of the year you contribute to a Roth IRA. Deadlines for a 2010 Roth IRA Conversion If you are planning a conversion in 2010 and your MAGI is less than $100,000 in 2009 contribute to a Roth IRA in 2009 to start the five-year holding period on January 1 st If you plan on converting your employer retirement plan verify that your plan allows in-service withdrawals and if so under what conditions. If you have an in service withdrawal option it is usually restricted to those age 59 ½ or older. Roth IRA modified Adjusted Income limitations disappear December 31 st Consider conversion on January 1, 2010 to convert prior to potential market value gains on your assets. Conversion Strategies: Timing: It is better to convert earlier in the year because: 1. Your Roth can be generating tax-free earnings for more than a year before you have to come up with the conversion tax. 2. Gives you more time to undo the conversion if your investments perform poorly. When in doubt, convert. You can always undo it without tax consequences by October 15 the following year. Page 10 of 12

11 If you don t qualify for an IRA or a Roth, possibly make non-deductable traditional IRA contributions with the intention of converting to a Roth in the future forward for high-income clients: If you don t qualify for a Roth make non-deductable IRA contributions and then immediately do a Roth conversion each year. Non-deductible IRA can only be converted as a percentage of all distributions of combined traditional IRAs and Non-deductible IRAs. Conversion and Adjusted Gross Income (AGI): Utilize your AGI to see how the conversion will affect your taxes. The most important breakpoint is between the 15% and 25% tax bracket; a jump of 10%. If you are in the 15% bracket and the conversion pushes you up to the 25%, you are paying a 10% penalty on the conversion. If this is the case, convert in installments to minimize taxes. Advantages of installments: If you do a partial conversion, you can recharacterize and immediately reconvert into a Roth with different money from the same IRA source. This would be advantageous to you in a falling market because you could lower the tax liability associated with the conversion. Also, it may be easier to come up with enough outside money to pay for the additional taxes on each installment. Disadvantages of installments: The market might go up and then you are converting a greater amount to a Roth later on, increasing taxes. You can back out a conversion if the market goes down, but you can t make it happen retroactively if the market goes up. Paying the tax: Generally, you should pay the conversion tax out of non-retirement funds to make a conversion worthwhile. Take last year s tax return and add on the tax for an estimate. There may be additional consequences such as a reduction in financial aid for a child in college. Keep the money you need to pay the conversion taxes in a conservative investment like a money market account or a CD to mature at the time the tax bill is due. New Account for Conversions: For the first year, open a separate Roth account from any of your other Roths so it is easier to undo the conversion at a later date. Using an Employer Plan to segregate non-deductible IRA contributions. If you have access to roll funds in and out of an employer retirement plan you could use a rollover to the employer plan to strip out nondeductible contributions. Employer plans cannot accept bases contributions so it is the one time you can roll only the pre-tax dollars to the plan. Then convert the basis, which you had already paid taxes on to Roth. You would only have to pay taxes on the earning from the non-deductible contributions. Once that is done you can roll the employer pension funds back into an IRA and convert them. If you do not have the ability to roll the money back to an IRA the advantage is lost. What the 2011 Federal Marginal Tax Rates Could Look Like; The Bush tax cuts expire after At expiration the tax rates will revert back to the 2000 tax levels. Married Filing Jointly Tax 2000 Rate Taxable Income 15% $0 - $43,850 28% $43,850 - $105,950 31% $105,950 - $161,450 36% $161,450 - $288, % Over $288,350 There is talk about leaving the tax cuts alone for the lower brackets but bringing back the 36% and 39.6% tax brackets for taxable incomes of $250,000 and above. Based on that information, we took the 2009 federal income tax brackets for married filing jointly (MFJ), which look like this: Page 11 of 12

12 Reference Materials: Married Filing Jointly Tax 2009 Rate Taxable Income 10% $0 - $16,700 15% $16,700 - $67,900 25% $67,900 - $137, % $137,050 - $208, % $208,850 - $372, % Over $372,950 If you take those numbers, add the new tax brackets, add a 3% inflation adjustment (for two years since 2005) to the brackets, and this is what we came up with: Married Filing Jointly Tax 2010 Rate Taxable Income 10% Not over $17,717 15% $17,717 - $72,035 28% $72,035 - $143,275 31% $143,275 - $250,000 36% $250,000 - $395, % Over $395,663 In addition to the new tax brackets, there s also talk of a surtax of 1% for families who make over $250,000, 2% for families who make over $500,000, and 3% for incomes over $1,000,000. These rates could double in limiting itemized deductions to 28% for incomes over $250,000. the possibility of the 1.45% Medicare tax being added to dividends. These numbers are pure speculation, and are based on our best estimate of the current legislative dialog Tax Increase Prevention & reconciliation Act- SEC.512 Conversion to Roth IRAs 2009 Go Roth Your guide to the Roth IRA, Roth 401(k) and Roth 403(b) by Kaye A. Thomas Fairmark Press 2009 Edition. IRS Publication 590 Individual retirement Arrangements (IRS) for use in 2008 returns. U.S. Code collection Cornell University Law School 408A. Roth IRAs and conforming amendment. Title 26 of the US Code as currently published by the US Government reflects the laws passed by Congress as of Jan. 8, Taxes The Tax Magazine Family Tax Planning Forum by Robert S. Keebler and Stephen J. Bigge October Forefield, Inc. An independent third party research provider. Tax Increase Prevention and Reconciliation Act of 2005, Public Law May 17, 2006 Jobs and Growth Tax Relief Reconciliation Act of 2003, Public Law May 28, 2003 Economic Growth and Tax Relief Reconciliation Act of 2001, Public Law June 7, 2001 Disclosure Information Important This information was developed by Candy J. Lee Financial Planning & Money Management. It is general in nature, is not a complete statement of all the information necessary for making a tax, legal or investment decision. Our respective advisors do not provide tax accounting, or legal advice. The strategies mentioned may not be appropriate or suitable for all investors. Any taxpayer should seek advice based on the taxpayer s particular circumstances from an independent tax advisor. This material is not intended to be used, nor can it be used by any taxpayer, for the purpose of avoiding U.S. federal, state or local tax penalties. Page 12 of 12

Beginning in 2010, the Tax Increase Prevention and ROTH IRA CONVERSION

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