ROTH IRAS: IS THERE A CONVERSION IN YOUR FUTURE? SHOULD THERE BE?

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1 KRISTI MATHISEN, JD AND CPA Who would have imagined that one of the hottest investment questions in years for individuals, tax professionals, financial planners and investment advisors would be about the opportunity to voluntarily pre-pay income tax and that this would all be based on a tax law change from 2006? Individuals and tax professionals have a long established belief that you should pay no tax before its time often quoted as defer, defer, defer. And financial planners and investment professionals generally advise against taking large taxable withdrawals from retirement plans and IRAs because of the length of time required to make-up for the big tax bills that those transactions create. Yet here we are with many people seriously considering whether to pay a lot of tax today to secure a possible tax benefit in the future. Why now? Certain tax law changes authorized by the Pension Protection Act of 2006 took effect this year. What has changed is that the opportunity to convert a retirement plan or Individual Retirement Account (IRA) into a Roth IRA is now available to almost everyone. Under prior law, the right to convert an account into a Roth account was limited to those with income of $100,000 or less and was never available to those who chose to file their income taxes as married, filing separately. What hasn t changed much is the tax toll that comes with conversion. TWO BIG ADVANTAGES OF ROTH IRAS What is so desirable about a Roth IRA? There are two major benefits of Roth IRAs. The first and most touted is that under current law, a Roth IRA grows tax-free forever. Traditional IRAs and qualified retirement plans grow tax free but their earnings (and usually almost all of the contributions) will eventually be taxed when the funds are withdrawn from the account. Additionally, this aspect of these accounts carries on after the death of the owner. In contrast, Roth IRA earnings and contributions, once the initial account qualification requirements have been 2013 LNWM 1

2 THE PAIN OF PAYING YOUR TAX BILL FROM RETIREMENT ACCOUNT FUNDS John s traditional IRA is worth $100,000 and is his only source for paying the conversion tax. John wants to convert $50,000, and let s assume he s in 28% tax bracket. His tax on $50,000 of income would be $14,000, but he ll have to withdraw $19,444 to have sufficient funds to pay the $14,000 tax on the conversion, plus the tax on the $14,000 he withdraws to pay the tax. You can see how circular and costly this can become and that s before you consider the penalty that would apply to the withdrawal for taxes if John is under age 59-1/2. He would have to pull out $22,254 to pay the income tax and the 10% penalty for early withdrawals. So, almost 22% of the account goes to taxes and penalties if the funds come from retirement assets compared to the income tax on the Roth conversion itself of only $14,000. satisfied, can be withdrawn tax free by the owner and the owner s heirs. Those who think that they will be subject to higher taxes in the future are among those considering paying taxes now at known, and perhaps comparatively, lower tax rates than would be applicable in the future. The other major benefit of Roth IRAs is that unlike traditional IRAs and qualified retirement plans, Roth IRAs don t have required minimum distributions (RMDs) during the life of the individual whose efforts created the IRA or earned the contributions to the retirement account. As a result, the owner never has to take funds from the Roth IRA unless he or she wants to do so. Many owners of traditional IRAs and retirement plans dislike having to take and pay income tax on withdrawals they don t need. TWO DISADVANTAGES The big negative of converting an account into a Roth IRA is that the tax paid to convert is equal to the amount of tax you would pay if it were cashed out. For conversions that occur during 2010, income is reported and tax paid as if 50% is income in 2011 with the balance reported as income in Basically, the owner gets to defer reporting and paying tax that would normally be due in the conversion year to future years. The risk with this is that the income is actually reported in those future years and is subject to whatever the tax rates and rules are in those years. Under current law, that means higher tax rates (36% and 39.6%, respectively) for those currently in the 33% and 35% tax brackets. To avoid the risk of a tax change, an owner can report all of the conversion income in 2010, but in a situation where an owner is making a large conversion, a big portion of the converted amount would be taxed at the highest tax rates LNWM 2

3 A second disadvantage is that the tax on the conversion should be paid from nonretirement accounts to avoid having to pay income tax (and possibly a penalty) on the funds used to pay income tax. Paying the tax to convert an IRA or retirement account into a Roth IRA can make a significant dent in a person s other assets. But paying the tax and possibly an early withdrawal penalty from retirement funds increases the total tax bill. WHAT ABOUT CONVERTING MULTIPLE IRAS? For those with multiple IRAs the temptation might be to cherrypick the most tax-favorable parts to convert, so you pay the least amount of conversion tax. Unfortunately, the rules don t allow that. If you have more than one IRA you don t get to chose to convert just the non-taxable portion. The ratio of after-tax dollars to the value of all IRAs must remain the same in the converted pool and non-converted pool. Here s an example: Jill has several IRAs that total $100,000 and her total after-tax contributions are $20,000 leaving $80,000 that is taxable. Let s say she wants to convert $50,000 in her IRAs to a Roth, or half of her total account value. In this scenario her after-tax contribution must be split in half as well so only one-half of the after-tax portion is reportable. Jill would be taxed on $40,000 of the $50,000 she converts. YOU GET A DO-OVER IF THE MARKET DROPS The taxable value of the account is determined on the date of conversion. Because most retirement accounts consist of marketable securities, this means that after conversion there is one certainty the value of the account will change. While most who convert contemplate the account increasing in value, there is always a chance of the opposite occurrence. No one wants to pay tax on a value that has declined. With Roth IRAs, the solution is to un-do the conversion which is called a recharacterization. Recharacterizations can occur as late as October 15 of the year after the year of conversion and can be implemented for any reason, not 2013 LNWM 3

4 just a decline in the account value. Recharacterizing is somewhat complicated administratively and if it occurs in the year after conversion, it requires amending tax returns but it is nice to have an out. WHEN PAYING TAX IS A GOOD THING Some people like the idea of paying the conversion tax. Who are they? People with large taxable estates whose estate taxes will be lower if the income taxes on IRAs and retirement plans are paid or incurred before they die. Under current tax law, traditional IRAs and retirement accounts are includible in a person s estate and subject to state estate tax and federal estate tax in years when there is such a tax. Currently for 2010, there is no federal estate tax but it resumes in These accounts, as noted above, are also subject to income tax, so the very same dollars can be taxed twice if the IRA or retirement account is liquidated to pay estate tax. Others who like the idea of paying the conversion tax are those who plan to leave their Roth IRAs to their children and think of paying the conversion tax as paying their kids taxes, a gift of sorts with no gift tax obligation. This is not unlike the popular but complex transactions involving defective grantor trusts. Almost everyone has some kind of tax-advantaged retirement account (either an IRA, or some kind of qualified employer-sponsored retirement plan like a 401(k) plan) that could be converted to a Roth IRA. In addition, a new rule applicable in 2010 allows those who inherit qualified employer-sponsored plans (but not IRAs) to convert those plans into Roth IRAs, even though they aren t the original owners or spouses. An important point to consider is that just because a person has a plan that could be converted to a Roth IRA doesn t mean that conversion is a wise move LNWM 4

5 Here are five favorable situations where it makes sense: 1. A PERSON WITH VERY LITTLE APPRECIATION IN AN IRA OR EMPLOYER PLAN THAT WAS FUNDED WITH AFTER-TAX DOLLARS WHO WON T NEED TO TAKE WITHDRAWALS FOR AT LEAST FIVE YEARS. This is especially true for those over age 59-1/2. This group includes the individuals who funded non-deductible IRAs during the past decade who have seen very little appreciation in their accounts. For them the income tax cost to convert will be quite low compared to the benefits of future tax free withdrawals of the account earnings and growth. Why age 59-1/2? Why a five-year wait? Because there is some fine print with regard to Roth IRA withdrawals. Tax-free withdrawals from a Roth IRA are not a slam dunk. If the Roth includes converted funds, those funds must stay in the Roth account five years to avoid early withdrawal penalties on the withdrawals and tax on the earnings. Furthermore, all withdrawals must occur after age 59-1/2 or because of death or disability to avoid an early distribution penalty. 2. THE INDIVIDUAL WHO DOESN T PLAN TO TAKE MONEY FROM THE IRA AND GETS JOY FROM PAYING THE TAXES OF OTHERS. THESE INDIVIDUALS ARE LESS MOTIVATED BY TAX RATE ARBITRAGE AND TRULY DON T WANT THEIR CHILDREN TO INHERIT AN INCOME TAX LIABILITY. They usually dislike the taxable required minimum distributions that can be avoided by a conversion. However, given the significant tax bite to convert, even these individuals should consider how much tax their children might pay on IRA and retirement plan withdrawals and when those taxes might be paid compared to the taxes the current owner will pay to convert now. 3. A DYING INDIVIDUAL WHO HAS A TAXABLE ESTATE AND WANTS TO SECURE AN ESTATE TAX DEDUCTION FOR THE INHERENT INCOME TAX LIABILITY OF AN IRA OR OTHER RETIREMENT PLAN. Current law allows an estate tax deduction for income taxes when a decedent has unpaid current income tax as of the date of death. This means that to secure the 2013 LNWM 5

6 deduction, a decedent s IRA or retirement plan would have to be distributed before death. Since Roth IRAs have the benefits of tax free growth, conversion is a good alternative to liquidating the retirement account to secure the tax deduction. While there is currently no federal estate tax, many states have an estate tax which could be reduced by the income tax liability from the Roth conversion. And the federal estate tax returns in 2011 under current law. 4. AN INDIVIDUAL WHO HAS FAVORABLE TAX ATTRIBUTES WHICH CAN BE APPLIED TO REDUCE THE EFFECTIVE TAX RATE ON THE CONVERSION INCOME. These tax attributes include net operating loss carryovers (prior year ordinary losses that can offset current year income), charitable contribution carryovers (charitable contributions from prior tax years that were not allowed as deductions because of adjusted gross income limitations), and tax credit carryovers (tax credits disallowed in prior years because they exceeded the individual s tax liability). 5. AN INDIVIDUAL WHO IS CERTAIN TO BE IN THE HIGHEST MARGINAL INCOME TAX BRACKET WHEN REQUIRED DISTRIBUTIONS MUST BEGIN AND IS CONVINCED THAT FUTURE TAX RATES WILL BE SIGNIFICANTLY HIGHER THAN TODAY S RATES. This is the individual who is purely motivated by tax savings. An important factor that these individuals should consider is that tax laws can change. There is no assurance that the Roth IRA rules of today will be retained. The range of possible changes in the law is wide but includes limiting the period of tax-free growth, possibly to the life of the owner or a specified term, or imposing an excise tax on retirement accumulations LNWM 6

7 OTHER IMPORTANT CONSIDERATIONS Others who are contemplating a Roth IRA conversion will have a more complicated decision to make, one that should be evaluated with the counsel of a tax advisor. There are multiple factors to consider including, but not limited to the following: How much tax can he or she afford to pay from non-retirement funds? What tax bracket would apply in the future when required minimum distributions would commence in the absence of conversion to a Roth IRA? Are withdrawals from the Roth IRA contemplated and, if so, when? Who are the beneficiaries of the retirement accounts and would a Roth IRA be helpful to them? What is the individual s sensitivity to tax law changes? How would he or she feel if, in the future, it is clear that they would have been better off not converting to a Roth IRA? WHAT ABOUT A PARTIAL CONVERSION? Another option to consider is converting only part of an eligible account to a Roth IRA. The benefits of doing a partial conversion include: Paying less in taxes currently than with the complete conversion option. Hedging your bets with regards to your future tax situation. This means you have some assets in the tax free forever Roth account, some in traditional retirement accounts, and hopefully some in other investment accounts. You achieve a type of asset diversification that provides flexibility for a future that is uncertain both as to taxes and investment performance. MAKE A DELIBERATE DECISION The decision to convert an account to a Roth IRA is significant, carrying both tax and financial planning consequences. Even if the conversion can be undone, this is a step to be taken carefully. Before converting an account into a Roth IRA, we encourage you to contact your CPA or other tax advisor for professional tax input. Many CPAs have sophisticated software to model outcomes and inform your decision LNWM 7

8 ABOUT THE AUTHOR Kristi Mathisen serves as Laird Norton Wealth Management s in-house expert on tax and estate planning issues. She provides advice on philanthropic strategies to the firm s client service team and to clients directly. She is an attorney and CPA and has more than 20 years of finance-related experience, much of it in accounting. Kristi has a bachelor s degree in business administration with an accounting concentration from the University of Washington and a Juris Doctor from the University of Washington School of Law. She is a member of the Washington State and King County Bar Associations, the Washington State Society CPA and the American Institute of CPAs. DISCLOSURE The information presented herein does not constitute and should not be construed as legal advice, as an endorsement of any party or any investment party or any investment product or service, or as an offer to buy or sell any investment product or service. The views and solutions described may not be suitable for all investors. All opinions expressed are those of Laird Norton Wealth Management and are current only as of the date appearing on this material. IRS CIRCULAR 230 DISCLOSURE: Pursuant to Circular 230 (U.S. Treasury Regulations governing tax practice), any tax advice contained in this presentation cannot be used by any taxpayer for the purpose of avoiding penalties that may be imposed. Laird Norton Wealth Management (LNWM) is comprised of two distinct entities that may offer the similar services to clients. Laird Norton Tyee Asset Strategies, LLC is an Investment Advisor registered with the Securities and Exchange Commission. Laird Norton Tyee Trust Company is a State of Washington-chartered trust company. 801 SECOND AVENUE, SUITE 1600, SEATTLE, WA LNWM 8