TOPIC: ROTH IRA CONVERSIONS IN 2010: THE NEW OPPORTUNITY William R. Urban, CFA, CFP, Co-Managing Principal

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1 Retirement Planning TOPIC: ROTH IRA CONVERSIONS IN 2010: THE NEW OPPORTUNITY William R. Urban, CFA, CFP, Co-Managing Principal The opportunity to convert existing IRA account balances into Roth IRA accounts has been available since 1998, but only for those with modified adjusted gross incomes (MAGI) that do not exceed $100,000 in the conversion year. Starting in 2010, that restriction is lifted permanently, and anyone with a qualifying IRA account may choose to do a conversion. This paper analyzes the strategies for taking advantage of the conversion opportunity, and quantifies the cost or benefit of doing a conversion under a wide range of assumptions. Our analysis highlights four main contributing factors to any benefits created by a Roth conversion: 1) Tax free growth and tax-free withdrawal of Roth assets over extended periods. 2) The ability to back-end load withdrawals from a Roth IRA to get more tax-free growth, either during retirement or in an estate planning scenario, because of the absence of required minimum distributions during the owner s lifetime. 3) The ability to minimize up-front taxation of the converted amount by using any or all of the following four tax minimization strategies: a) converting amounts over multiple years to reduce taxes; b) for 2010 conversions only, the option to include the conversion amount wholly in 2010 income, or to split it equally between 2011 and 2012 tax years; c) recharacterization and reconversion strategies that allow participants to unconvert and then reconvert without penalty if the converted asset declines in value after the date of original conversion; and d) increasing the effective cost basis percentage in the conversion assets. 4) The ability to preferentially hold that portion of total portfolio assets with the highest expected long term return potential in the Roth IRA to take maximum advantage of long term tax-free growth and withdrawals. As we shall see, the benefit of each of these strategies individually may be modest, but in combination can make the Roth conversion option very attractive.

2 The framework of the analysis is shown in Figure 1. Figure 1: Framework to Analyze Holding a Traditional IRA versus Converting to a Roth IRA An owner of a traditional IRA(s) may choose to convert any amount up to the full value of his IRAs to a Roth conversion IRA. The amount of the conversion (less any portion attributable to non-deductible contributions) will be treated as taxable income, and included in the owner s ordinary income for tax purposes in the year of conversion (with a one-time exception for 2010 conversions.) Therefore, in return for getting Roth assets that are free of taxation on any earnings growth or distributions during his lifetime, he incurs an opportunity cost of the foregone ability to hold and invest the money that is used to pay taxes on the conversion amount. These monies, if held and invested in a taxable account, can be evaluated as a supplemental account that can provide for retirement income, along with traditional IRA assets that are not converted. The framework of the analysis compares the lump sum value, or the retirement income annuity, that can be delivered by the Roth conversion assets versus the sum of the aftertax traditional IRA lump sum or annuity values, plus the supplemental (tax savings) account s lump sum or annuity values. 2

3 A sample of our inputs and modeling tool is shown in Figures 2 and 3. Figure 2: Assumptions in Base Case Scenario BASE CASE SCENARIO Owner A Owner B Age Assets in Traditional IRA $100,000 $100,000 Assets in Taxable Account Accumulation Period Prior to IRA Withdrawals Making a Roth Conversion in 2010? $35, Years No $35, Years Yes Age Withdrawals Begin Years of Equal Annual Distribution in Retirement Current Ordinary Income Tax Bracket Current Capital Gains Tax Rate Ordinary Income Tax Bracket During Retirement Capital Gains Tax Rate During Retirement Making a Roth Conversion in 2010? Ordinary Income Tax Bracket if Conversion Completed & Reported in 2010 Ordinary Income Tax Bracket if 2010 Conversion Reported in 2011 & 2012 Investment Rate of Return Percent of Taxable Account Income that is Capital Gain % 20% 30% 20% No N/A N/A 7.5% 60% % 20% 30% 20% Yes 35% 39.6% 7.5% N/A

4 Figure 3: Sample Summary Results from Roth Conversion Analysis Tool Base Case Consider an owner of multiple traditional IRA accounts, with AGI exceeding $100,000, who is evaluating whether to do his first Roth conversion early in The account owner is 50 years of age, and has $100,000 in traditional IRA assets consisting entirely of pre-tax assets from a 401k plan rollover. Suppose also that this owner expects to be in the 35% blended federal/state marginal tax rate for 2010, and will stay at that marginal 4

5 rate even if the full $100,000 amount is converted. We further assume that the owner s marginal tax rate in 2011 and 2012 will go up to 39.60% with the expiration of the Bush tax cuts. Capital gains taxes will stay at 20% indefinitely, including the owner s retirement period. However, assume the owner s marginal ordinary income tax rate will drop to 30% during his retirement years, expected to start in 20 years when he turns 70. Also assume that he earns a flat 7.5% annual rate on all investments, and that after reaching age of 70, the owner withdraws his retirement savings evenly over a 20-year retirement period. If this owner chooses to do a Roth conversion of the full $100,000 in 2010 and include the income on his 2010 tax return, he will owe income taxes of $35,000 on the conversion. Assume he pays the taxes from an existing taxable account so that the full amount of the $100,000 conversion stays in the Roth IRA. Alternatively, if he does not do the conversion, the $100,000 stays in the traditional IRA, and the $35,000 that would have gone to pay taxes continues to stay invested in his taxable account. Which scenario is better in terms of after-tax income in retirement? In this case, it is the Roth conversion scenario, with our owner withdrawing $38,761 annually tax-free in retirement, versus $ 35,430 after-tax from the combination of the traditional IRA and side account that grew from the original $35,000 tax savings. That represents a 9.4% increase in after-tax income, or an increase of about $66,620 in total after-tax withdrawals. What if the assumptions in our original example change? What conclusions can we draw about how favorable (or unfavorable) the Roth conversion option might be? Table 1 shows of the results of changing one variable at a time compared to the base case scenario just described. (Table 1 shown on next page.) 5

6 Table 1: Sensitivity Analysis 6

7 If our owner is younger, and has more years of accumulation before retirement age, the benefit of the conversion increases. A 40-year old worker, ten years younger with 30 years of accumulation, would expect a 13.9% benefit to conversion, or 17.9% with 40 years of accumulation, about a 0.45% increase in benefit for each extra year of the accumulation period. A 60 year old worker with only ten years of accumulation would see a modest 4.5% benefit, and for a worker right at the point of retirement at age 65, the conversion option gains only 1.9% over the do not convert option. Deferred Withdrawals and Roth IRAs for Estate Planning Going back to our original 50 year old owner with 20 years of accumulation, what happens if he makes no or lower withdrawals from his Roth account early in retirement and larger withdrawals later in retirement? He would also be able to increase the benefit of the Roth over the 20-year equal distribution strategy. For example, if our Roth IRA owner deferred any distributions for the first 10 years past age 70, and then emptied the IRA with level distributions over the next 10 years, the benefit of doing the conversion rises dramatically from 9.4% to 22.2%. Even a modest deferral of withdrawal for two years past age 70 increases the conversion benefit to 12.0%. In the case in which no Roth distributions are taken until the end of the final 20 th year past age 70, the resulting $1,804,424 complete tax free distribution has a net present value of $213,673, a 43.0% advantage over the net present value of the total income stream from the no conversion scenario. In the special case for estate planning purposes, the Roth conversion strategy has a huge advantage over the traditional IRA because there are no mandatory distributions. This allows the entire Roth balance to continue to grow tax free during the lifetime of the originator and beyond. In the example above, if the investor lived to age 90 without having taken any Roth distributions, the conversion strategy delivers a 43.0% net present value advantage, to that point, over the traditional IRA distribution. If the investor then died, although possibly subject to estate taxes, the Roth IRA can be left to younger beneficiaries and withdrawn tax-free over their life expectancies. In other words, the net present value benefit achieved during the life of the original investor can be increased by extending the tax-free growth during a greatly elongated distribution period in the hands of the next generation. Additionally, the Roth IRA offers the flexibility to skip or target a specific withdrawal amount based on personal circumstances, a flexibility that is greatly diminished in the traditional IRA where required minimum distributions (RMDs) must be taken after age 70 ½. 7

8 Sensitivity Analysis Table 1 illustrates the effect of changes in numerous other variables, including tax rates, cost basis, and rate of return on investments. The effective tax rate can have a significant impact on the overall attractiveness of doing the conversion. Fortunately, it is also one of the variables that IRA owners have the most control over by how they implement the Roth conversion. Our base case assumptions assumed a 35% marginal tax rate on the $100,000 conversion. If, however, the marginal tax rate increased to as high as 49.0% as a result of the extra income pushing the owner into a much higher marginal tax bracket, the 9.4% benefit of the Roth conversion would be completely eliminated. In fact, for each 1% increase in the conversion tax rate ($1,000 extra tax), the percentage benefit of doing a conversion drops by about -0.7%. Fortunately, it also turns out that lower effective marginal tax rates (by utilizing the strategies we discuss later in this paper) can increase the benefit of conversion by about the same 0.7% for each 1% decrease in the tax rate. For example, if the effective conversion year tax rate could be reduced by 5%, from 35% in the base case to 30%, the Roth conversion benefit increases to 13.2%. One way the effective tax rate might decrease is if some portion of the converted assets comes from IRA contributions that were previously taxed, i.e. came from non-deductible contributions. For example, if we assume that $10,000 of the $100,000 conversion amount in our base case has been previously taxed, then only $90,000 of converted assets is subject to the 35 % tax rate. This would reduce the tax bill to $31,500 (an effective tax rate of 31.5% of the full $100,000 conversion amount), and increase the benefit of converting to 11.5%. However, reducing the effective tax rate on conversion by this means does not increase the conversion benefit as much as in the previous example (here, each 1% change in the tax rate results in about 0.6% change in benefit). This is because the benefit of having tax basis in an IRA will also be captured by the comparison scenario of not doing a conversion, since that portion of future distributions from traditional IRA s will also be free of tax. Many traditional IRA owners may be reluctant to make a Roth conversion, figuring that if they expect to be in a lower bracket in retirement, paying a higher tax rate now on the conversion is not a good bet. In fact, we calculate that the marginal tax rate in retirement would have to drop to 21.8% (a nominal 13.2 percentage point drop from the base case assumption) before the 9.4% conversion benefit is totally eliminated. As shown in Table 2, that much of a retirement tax rate drop is extremely unlikely. 8

9 Table 2: Will Tax Rates Be Lower in Retirement? Finally, we analyzed the impact of changes to expected annual investment total return on IRA assets from the 7.5% assumed in the base case scenario. The benefit of doing a conversion, measured in terms of percent more retirement income, rises at about a 1.4% rate for each 1% increase in the annual investment return. An assumed 8.5% annual return (a 1% increase) results in a 10.8% conversion benefit, while a lower 6.5% annual return results in only a 7.9% conversion benefit. Figures 4, 5, and 6 illustrate the size of the Roth conversion benefit as a function of age, tax rate change, and rate of return, respectively. In each case, all other assumptions of the base case scenario are held constant. 9

10 Figure 4: Roth Advantage: Conversion Benefit vs. Age 20% Roth Advantage (%) 16% 12% 8% Base Case 4% 0% Age of Participant Incremental retirement income(after tax). Reflects base case assumptions. Assumes marginal tax rate in retirement is 5% less than in conversion year. Figure 5: Roth Advantage: Conversion Benefit vs. Tax Rate Tax Rate Chg. Conversion Yr to Retirement Yrs 0% 5% 10% 15% 20% 25% Roth Conversion IRA is Better Traditional IRA is Better Breakeven Point Age 10

11 Figure 6: Roth Advantage: Conversion Benefit vs. Rate of Return Benefit (%) of Conversion Base Case Annual Return (%) Minimizing Taxes One way to increase the advantage of a Roth conversion is to reduce the effective tax rate on the conversion amount. There are multiple ways in which this can be done. One alternative is to carefully plan a multi-year conversion strategy, and convert assets in each year that, when added to other taxable income, will not subject the owner to higher marginal tax rates on some or all of the conversion assets. This strategy requires careful planning and measurement of other income throughout the year, and adjustment of the conversion amount to stay within lower brackets. Fortunately, because of the recharacterization/reconversion strategy described below, it is not necessary to wait until the end of the year to make a conversion, hoping to have better information on where the owner s taxable income is likely to come out. You can do a conversion on any eligible IRA assets early in the year (to capture more tax free growth) and then reverse any amount of the conversion before filing your taxes such that only those converted assets that come to the top of the current tax bracket are taxable. The same approach can be applied in future years until the desired amount of total assets are converted to Roth IRAs. While this strategy may help reduce the tax cost of converting, it also potentially costs something - earlier tax-free growth by converting more assets to Roth accounts now 11

12 rather than waiting to future years, when the assets may have increased in value and with that growth then subject to taxation upon conversion. Also, tax rates may be higher in future years due to tax law changes. Congress has provided IRA owners with an attractive inducement to consider Roth conversions in For any IRA assets converted to a Roth IRA in 2010 only, the taxpayer can elect to either 1) include the value of converted assets in his 2010 taxable income, or 2) split the income equally between 2011 and Furthermore, the IRA owner does not need to make this election until the due date (plus extensions) of his 2010 tax return, which effectively gives him until October 15 of 2011 to evaluate his tax situation and any new tax rates for 2011 and 2012 before choosing how to report. In many cases this will allow an account owner to get the benefit of early Roth conversions and tax free growth, while still allowing him to mitigate the risk of being pushed into higher marginal tax brackets by splitting the income between two years. The prospect of higher marginal income tax rates with the expiration of the Bush tax cuts after 2010, and new proposals for higher rates on the two current highest brackets (33% and 35%), make it difficult to determine which option might be better. We have modeled this choice for our base case scenario, assuming a 2010 conversion, changing only when the conversion amount is reported for tax purposes. Recall that in our base case, our IRA owner pays a 35% tax rate on the conversion amount if reported in If that same 35% tax rate is the effective rate for both 2011 and 2012, and our owner takes the election to defer and split the income between those two years, the benefit of doing the Roth conversion increases to 11.4% from the base case value of 9.4%. If the effective tax rates in 2011 and 2012 are actually lower than in 2010, as in a case where the rate drops to 33% in each year, the benefit climbs to 12.8%. On the other hand, if tax rates turn out to be higher in future years, the benefit could be reduced. For example, if the effective tax rate increases from 35% to 39.6% in 2011 and 2012, even after splitting the conversion income between those two years and delaying the payment of taxes, the benefit of the Roth conversion would be reduced to 8.3%. The reduction is not greater because the benefit of getting the full conversion amount growing in 2010 tax free in a Roth IRA will partially compensate for the higher future tax rates. Clearly, the ability to wait until late 2011 to make a final decision about when to recognize the income allows the account owner greater control over uncertain future events. Recharacterization and Reconversion Strategies The original law establishing Roth IRAs and conversions provides an option that can help reduce taxes. Recall that the original law would not allow a Roth conversion for anyone with modified AGI (excluding the conversion value) exceeding $100,000. Congress also realized that many individuals could not be sure until well after the end of the tax year whether their MAGI would be over or under $100,000, at which point it 12

13 would be too late to initiate a Roth conversion in the year that had just passed. Therefore, Congress provided an option that would allow anyone who thought their AGI had at least a chance of coming in under $100,000 to do a conversion in the current tax year and then, if their MAGI turned out to be above the limit, to do a recharacterization of the disallowed conversion without any penalty, provided the recharacterization was completed before the tax return due date (plus extensions) for that tax year. The recharacterization was accomplished by simply transferring the originally converted Roth IRA assets, plus any earnings or changes made to those investments, back into a traditional IRA, with no penalty or loss of earnings. It would be as if the original Roth conversion had never happened. Fortunately, Congress never restricted the use of the recharacterization option to just those taxpayers who exceed the $100,000 MAGI limit, and it will remain a choice even after the $100,000 limit is lifted. The technique can be used by anyone and applied in combination with the reconversion option, which states that Roth conversion assets that are recharacterized back to a traditional IRA can then be reconverted to a Roth IRA a second time, provided the reconversion does not happen in the same calendar year as the original conversion, and that it happens at least 30 days after the recharacterization, whichever is later. That allows an owner to reduce the taxes due by first converting assets to a Roth IRA, and if the value of those new Roth assets subsequently declines in value, recharacterizing them back to a traditional IRA. He can then reconvert them to a Roth IRA (after the above waiting period), owing less taxes on the now lower value of the converted assets. The effect of this is to boost the benefit of doing a Roth conversion versus leaving assets in a traditional IRA. There are some important restrictions to keep in mind. If you do a Roth conversion to a single new or existing Roth account, and then want to recharacterize just the assets that have declined in value, you can t you either have to recharacterize the entire account, or you have to do a pro rata recharacterization based upon the value of all investments held (no matter which asset or assets you choose to transfer back to the traditional IRA). However, by setting up multiple new Roth accounts to receive conversion assets, and by transferring different investments into each, you can selectively pick those accounts, if any, that have declined in value to recharacterize and then reconvert, thus lowering the resulting taxable income. Ideally, you might convert different types of uncorrelated investments into separate new Roth accounts, and then recharacterize and reconvert any that drop in value while continuing to hold onto the Roth conversion accounts that have held or appreciated in value. In horse racing parlance, Congress has given IRA account owners the option to bet on all the horses(different investments) in a race, cash in the winning tickets, and then apply for a refund on the losing tickets so that the refunds can be applied to the next race. 13

14 The example in Table 3 illustrates how this technique can reduce the tax due and boost the benefit of a Roth conversion. Table 3: Roth Conversion Analysis Rate of Return Ending Value Action 35% $ 30,000 REITS 6.00% $31,800 HOLD $10,500 $ 30,000 S&P % $34,800 HOLD $10,500 $ 20,000 Foreign Stocks 29.50% $25,900 HOLD $7,000 $ 20,000 Commodities % $15,000 Recharacterize/Reconvert $5,250 $ 100,000 Total 7.50% $107,500 $33,250 Tax Savings $1,750 Effective Conversion Tax Rate 33.25% Normal Tax Rate 35.00% Incremental Tax Rate Benefit 1.75% Clearly, even in an up year, it is possible that at least some investments in a portfolio may have negative returns and a drop in value. As long as they are identified and recharacterized before the tax filing deadline, the resulting taxable income from these underwater assets can be eliminated. A diversified portfolio that has the maximum number of highly uncorrelated or even negatively correlated assets in separate Roth conversion IRAs can most benefit from this technique. In normal investment years, the complexity of managing multiple Roth conversion accounts may not seem worth the trouble based on the low likelihood of a major drop in account values that would make the benefit of recharacterization and reconversion significant; nevertheless, it should be considered a bit of an insurance policy against a major decline in asset values like we saw in Although recharacterization does not erase the loss in account values, it at least affords the account owner an opportunity to reconvert at lower tax cost and capture any recovery of asset values tax free. 14

15 An additional benefit of this option is its flexibility in handling a change in expected tax rates between the original conversion year and the reconversion year. For example, if an investor implemented a Roth conversion in the current year, and then realized late in the year that his marginal tax rate might be much lower in the following tax year (as a result of a job loss, lower bonus expectation, etc.), he could do a recharacterization and then reconvert in the new year (after fulfilling the 30-day waiting period) such that the conversion amount would be subject to a lower marginal tax rate. In some cases, this might be worth doing even for a Roth IRA that has increased in value, if the benefit of the lower tax rate exceeds the growth in the originally converted Roth IRA account. Here are a few tips on how to implement the recharacterization strategy. 1) If this is your first year of creating a Roth IRA account, and you recharacterize a conversion, leave a few dollars of assets behind in at least one of your Roth IRA accounts. That keeps the 5-year clock running (as of January 1 of the conversion year) on the minimum holding period required for qualified tax free withdrawals from any Roth IRAs. Any future reconversions or new conversions to Roth accounts will automatically be grandfathered under the original 5-year holding period. You must also be at least 59-1/2 for any Roth withdrawal to be qualified and tax free. 2) After the reconversion deadline has passed, you can combine all such Roth conversion accounts into one for ease of administration. The only benefit to keeping them separate is for purposes of recharacterization and reconversion. Roth Conversion Tax Basis The fourth strategy that can help reduce taxes is to increase the value of the cost basis of IRA accounts as a percentage of the total conversion value. Income tax applies to the total conversion value less the cost basis (value of previous non-deductible contributions). Under current conversion rules, the cost basis amount is assumed to come pro rata from all of the owner s traditional IRA accounts, regardless of which account he actually uses as the source for conversion assets. Consider an example in which an owner has two IRAs, a contributory IRA worth $100,000 that includes $20,000 of nondeductible contributions, and a second $100,000 IRA that originated from a 401(k) rollover with no after-tax contributions. If the entire $200,000 is converted, the $20,000 of non-deductible contributions, or cost basis in the first IRA, are excluded from taxable income, such that $180,000, or 90% of the total conversion is taxable. However, if the account owner wanted to convert just $100,000 total, he could not earmark the contributory IRA, with $20,000 of cost basis, and report only $80,000 ($100,000-$20,000) of taxable income (resulting in 80% of the converted amount being taxable). He must treat the $100,000 conversion amount as coming ratably 15

16 from both IRA s, which means only $10,000 of the $20,000 tax basis in the contributory IRA can be used to reduce the taxable conversion amount, resulting in a consistent 90% of the total conversion being taxed. Account owners can still make some decisions that will increase the cost basis recognized upon conversion. One technique is to make as large of a non-deductible IRA contribution to traditional accounts as possible before doing a conversion. For example, any non-deductible contributions that could be made for calendar year 2009 or 2010 should be made before a conversion. Owners should also avoid doing anything that might reduce their cost basis as a percentage of their total IRA holdings before doing a conversion. An example would be to avoid rolling a large 401(k) plan with no after-tax contributions into an IRA before doing only a partial Roth conversion, because the large rollover would dilute any cost basis exclusion percentage that might otherwise apply. Furthermore, married couples might choose to preferentially convert the IRA assets of the spouse that has the highest cost basis as a percent of their total individual IRA accounts. Likewise, unmarried couples might consider preferentially converting the IRA assets of the individual with the lowest marginal tax bracket in the conversion year. In our base case for an IRA owner doing a $100,000 conversion, we assumed that he had no cost basis in his IRA accounts. However, if he did have as much as $10,000 of previously taxed contributions, such that only $90,000 of the $100,000 of conversion is taxed, he would save $3,500 in taxes and increase the benefit of doing the conversion from 9.4% to 11.5%. Allocation of Investments between Traditional and Roth IRA Accounts The fact that earnings within traditional IRA accounts will ultimately be taxed and that those within Roth IRA accounts will not suggests that there might be an optimum decision for allocating investments between the two. Indeed, we might take advantage of the tax-free nature of the Roth IRA to hold those assets with the highest total return potential, and use the traditional IRA to hold those assets with lower total return possibilities. That would allow us to maximize the total after-tax distributions. 16

17 Figure 7: Highest Return Assets in Roth IRA Extra Benefit(%) of Roth Conversion over Base Case Age 8.5% ret, 35%/30% tax 9.5%ret, 35%/30%tax Holds total annual return across Roth & Traditional IRA at 7.5% Assumes conversion of 50% of all IRA assets Figure 7 shows the incremental benefit in after-tax retirement income of segregating assets between accounts, as a function of years of accumulation and marginal tax rates. Starting with the original assumptions from our base case scenario, assume that exactly one half of all IRA assets have just been converted to Roth IRAs. Assume a total return from the combination of all Roth and traditional IRA accounts of 7.5% annually, but that assets earning a higher return of 8.5% annually are held in the Roth IRA, meaning that the remaining assets held in the traditional IRA earn a lower return. These assumptions ensure that the overall aggregate return on all accounts totals 7.5% and that the overall allocation remains constant, allowing us to isolate of the impact of the allocation decision between the two accounts. No new contributions are made to Roth or traditional plan balances during the analysis. The result would be an incremental 3.2% total gain in retirement income across all IRA accounts simply by successfully allocating higher returning assets to the Roth IRA. The incremental advantage would increase to 7.0% if it were possible to reliably allocate assets returning 9.5% annually to the Roth IRA while still holding total return across all Roth and traditional IRA s at 7.5%. If we apply the same approach to an investor that is 10 years younger and 10 more years of accumulation, but identical to our original investor in all other respects, the 17

18 incremental advantage of this preferential asset allocation is 5.1% and 11.8% respectively for the two Roth return assumptions. Figure 7 also demonstrates that this incremental Roth advantage is larger as the marginal tax rate increases. These are significant additional benefits to converting at least some traditional IRA assets to Roth accounts, because they are additive to the Roth benefits discussed earlier and involve no more overall investment risk or changes in overall asset allocation. Planning Steps 1) Identify all accounts eligible for Roth conversion, and select the accounts and assets that you will make conversion-ready as IRA s. These may include contributory, rollover, SEP and SAR-SEP IRAs, Keogh plans, profit sharing or money purchase pension plans, and frozen or terminated self-employed defined benefit plans from which there is a distribution. It can also include IRA rollovers from previous employer 401(k) or 403(b) plans. Current 401(k) or 403(b) balances may be eligible for an in-service withdrawal to a traditional or Roth IRA for those 59 ½ and older, if allowed by the plan. Check with your employer to see if in-service withdrawals are permitted, and what the restrictions and limitations are. 2) Determine the market value and total cost basis in all accounts eligible for Roth conversion. 3) Run a Roth conversion analysis to quantify the benefit of doing the conversion under a range of possible scenarios. 4) Plan the amount and timing of Roth conversions to balance the twin objectives of minimizing taxes and starting tax free growth as soon as possible. In addition to pushing a taxpayer into a higher tax bracket, a large conversion amount may further increase taxation by reducing deductions and exemptions, exposing a larger share of any Social Security income to taxes, and increasing the share of Medicare payments. In some cases, it could affect eligibility for college financial aid, or may subject certain taxpayers to the alternative minimum tax, among other items, so these possibilities should be carefully evaluated. 5) Identify the source of cash to pay taxes due. As we have discussed, the due date for tax payment can be delayed in some cases for several years, but it is still important to ensure you will have a source for the taxes without having to take it from the amounts you intend to convert to a Roth IRA. 6) Establish multiple Roth conversion accounts, one for each major asset or investment type you intend to buy or hold. That allows you to take advantage of the 18

19 recharacterization option if any investments decline in value. After the deadline for recharacterization and reconversion has passed, the multiple Roth accounts can be collapsed together. 7) Make any allowable non-deductible traditional IRA contributions before you execute the Roth conversion, in order to increase your cost basis in IRA accounts and reduce taxes. 8) If eligible, take advantage of the temporary suspension of RMDs from IRAs in 2009 to make higher IRA account balances available for Roth conversions in 2010 (RMD amounts due in 2010 are not eligible for conversion in 2010.) 9) Couples should plan their conversion strategies to take maximum advantage of the IRAs with the highest cost basis. We at Bingham, Osborn & Scarborough, LLC (BOS), are ready to work with clients, their attorneys and tax professionals on the merits and specifics of these and other financial and estate planning options. For additional information on this or related topics, or to learn more about the investment management and financial planning services offered by BOS, please visit our web site at 19

20 DISCLOSURES: This document is not intended to be used as a general guide to investing, or as a source of any particular investment recommendations, and makes no implied or express recommendations concerning the manner in which any client's account should or would be handled, as appropriate investment strategies depend upon the client's investment objectives. It is the responsibility of any person or persons in possession of this material to inform themselves of and to take appropriate advice as to any applicable legal requirements and any applicable taxation regulations which might be relevant to the subscription, purchase, holding, exchange, redemption or disposal of any investments. This document does not constitute a solicitation in any jurisdiction in which such a solicitation is unlawful or to any person to whom it is unlawful. Moreover, this document neither constitutes an offer to enter into an investment agreement with the recipient of this document nor an invitation to respond to the document by making an offer to enter into an investment agreement. The portfolio risk management process includes an effort to monitor and manage risk, but does not imply low risk. Past performance is not indicative of future results, which may vary. The value of investments and the income derived from investments can go down as well as up. Future returns are not guaranteed, and a loss of principal may occur. Opinions expressed are current opinions as of the date appearing in this material only. No part of this material may, without the prior written consent of Bingham, Osborn & Scarborough, LLC, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient. 20