Is the Roth IRA conversion a gamble?

January 2010 | Dental Products Report
Think like a CEO

Is the Roth IRA conversion a gamble?

Understanding the 2010 IRA-to-Roth IRA conversion opportunity.

by J. Haden Werhan, CPA/PFS, of Capital Performance Advisors

Photo: Jupiterimages/Getty Images

It’s 2010, and it’s official. With the advent of the new year, we also face an intriguing new tax-planning option, one that offers us both opportunities and challenges, especially during 2010–2112. It’s the arrival of new IRA-to-Roth-IRA conversion rules. Now that they’re here, it’s worth taking a bit of time from your daily practice routine to consider what they mean to you, your wealth, and your retirement and estate planning needs.

Should you convert?
There are a variety of reasons you may decide to convert your traditional IRAs to Roth IRAs, which have two major advantages over traditional IRAs:
First, Roth IRA distributions are tax-free if they are qualified distributions. To be qualified, they must be made after a five-year holding period has passed and after the accountholder reaches age 59½.

Second, Roth IRAs are not subject to the required minimum distribution (RMD) rules that apply to traditional IRAs. Therefore, a Roth IRA accountholder who reaches age 70½ does not need to begin taking distributions; instead, the funds can continue to grow tax free until they are needed or are passed to heirs.

The tax-free nature of Roth IRA distributions may help you avoid higher tax brackets that would otherwise apply if you were withdrawing distributions from a traditional IRA. Moreover, these distributions-unlike those from traditional IRAs-do not affect the calculation of tax owed on Social Security payments.

You should consider an IRA-to-Roth-IRA conversion if any of the following apply to you:

• You can afford to pay the tax on the converted amounts from an account other than the IRA.
• You expect to be in a higher tax bracket in the future or have certain favorable tax attributes that will lower 2010-2012 taxable income.
• You have enough time before retirement to allow assets to grow tax-free and recoup dollars lost due to the taxes upon conversion.
• If you have an estate tax problem.

By specializing in full-circle levels of service for dentists, Capital Performance Advisors can expertly address your professional, financial and wealth aspirations through seamless applications of personal and institutional wealth management, as well as tax, estate and retirement planning. Visit cpacapital.com for more information.

How it works
Before you start immediately filling out the conversion paperwork, it’s important to assess a few essential details on how the conversion rules work and how they may impact you one way or the other.

First, it’s important to understand that an IRA conversion is treated as a taxable distribution. It’s taxed as ordinary income at your marginal tax rate (although it does not trigger any early withdrawal penalty, as an ordinary withdrawal would). This in effect accelerates the taxable income that you would eventually have had to pay on distributions from a traditional IRA when you retire. It does so in exchange for never taxing any future appreciation in the value of your account. This can be a significant tax advantage for some taxpayers …but it may or may not be an advantage for you.

Second, if you do choose to convert in 2010 and pay the taxes sooner than later, you face another decision on exactly how soon. Although conversion to a Roth IRA triggers immediate taxable income, Congress has provided a special incentive in 2010 to jump-start Roth conversions under the new rules: In 2010 (and 2010 only) you must elect one or the other of these two options: You can recognize all the conversion income in 2010. Or, you can average it over 2011 and 2012, spreading taxes on the converted amount over the rates in effect during those two years.

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Tips and traps

There are numerous techniques that can be used to maximize the benefits associated with the IRA to Roth conversion, depending on the long-term objectives you have for your IRA and its assets.

Here are a few pointers:

• Having retirement funds in a Roth IRA gives you additional tools for long-term, wealth-management levels of planning. For example, you will have one more choice when deciding which money to first draw in retirement: personal, already-taxed funds, retirement plan funds or your Roth account.
• When planning for your Roth IRA conversion, consider your tax and financial circumstances, but also think of your heirs. In other words, consider the estate and advanced planning implications of an IRA-to-Roth-IRA conversion. Income tax now may be much less than estate tax later.
• Doctors with larger, diversified portfolios should consider rolling their IRAs into more than one Roth IRA. If you have different asset classes, consider separate Roth IRAs for each asset class. A pre-2010 conversion rule that remains in force allows you to recharacterize or “un-do” your conversion after the fact -by account. You can recharacterize as late as April 15, 2011 when you file your 2010 tax return, or Oct. 15 if you file an extension. If you’ve cleverly established a separate account for each asset class, this means you have quite a bit of time to examine how each asset class has performed since it was converted, and un-do particular asset classes, by account, that have declined in value. If asset classes are all mixed within one account, you cannot make these sorts of wise portfolio allocation choices. It’s all or nothing, hence the need for multiple Roth accounts.
• Believe it or not, you can re-convert that recharacterized traditional IRA to a Roth IRA subject to some additional time constraints. How often do we get do-overs any more?
• If you put your 2010 tax return on extension until October 15, you still have to pay any tax created by the conversion by April 15, 2011 to avoid underpayment penalties. If your conversion remains in effect, your tax is all paid. If you recharacterize the Roth back to traditional, you can file your tax return accordingly and request a refund of the overpaid tax.

Third, even if you can chart out your own expected income during the coming three years, several forces beyond our control take an already interesting tax-planning equation and create even greater challenges. For some taxpayers, their tax rate may rise after 2010 even if their income does not. This is because The Economic Growth and Recovery Act of 2001 expires and the top (maximum) tax bracket of 35% goes away with it. In its place, pre-2001 marginal income tax rates return in 2011, including the top two brackets of 36% and 39.6%.

It’s possible increases will be even higher than scheduled. How so? President Obama’s 2010 budget proposal makes permanent the 10%, 15%, 25% and 28% individual income tax brackets. This would be good for individuals with taxable income of less than $190,650 and for married couples filing jointly with taxable income less than $231,300. But in 2011, as mentioned above, the 33% and 35% rate brackets become 36% and 39.6%, respectively, which means you won’t need to earn as much to reach the 36% bracket. Will all of this actually happen? We don’t know, but stay tuned for developments as budget, health care reform and other initiatives work their way through Congress.

For now, you can at least think of it as an automatic tax increase of some sort or another, beginning in 2011. If you do not want to take the chance that your income tax rates will be higher in 2011–2012 than in 2010, you may elect to pay the full tax on the Roth conversion in 2010.

Clearly, deciding whether to convert from traditional to Roth requires some careful planning for tax years 2010–2012. This is especially so if your income is subject to fluctuation, as is the case among many dental professionals given the recent economic turmoil. It also requires assessing the optimal way to report a conversion taken, and calculating proper payment of estimated taxes thereon. And remember, the Roth conversion is not an all-or-nothing proposition. You may convert as little or as much of your traditional IRA as you want.

Applying it to you and yours

If you are planning to take advantage of the Roth IRA conversion opportunity, consider some of the following:

• Because of the economic slowdown, many individuals are postponing retirement. Roth IRAs, unlike traditional IRAs, generally have no age limitation on contributions from earned income or on mandatory payouts. This is an advantage if you are extending your career beyond traditional retirement age.
• If you can make deductible IRA contributions for 2009 before your tax return is due on April 15, we recommend you consider doing so. It can help reduce your 2009 tax bill. If you then convert the contributions to a Roth IRA in 2010, you will not have to pay back the tax savings until 2011–2012 (if you elect to ratably pay the tax over that two-year period). 
• Additionally, you may want to consider making non-deductible IRA contributions for 2009 and 2010, because you can later roll over the amounts into Roth IRAs at no tax cost.

Seek professional assistance

Just as you might seek the advice of a specialist for a particularly complex treatment plan for a patient in your dental practice, the best advice on how to sort through the many possible benefits and considerations related to the new 2010 Roth Conversion rules is to contact a trusted advisor to discuss your personal situation. Some of this planning is straightforward, but as you drill down into each facet of how a Roth conversion can affect you long term, you are really looking at some very advanced planning.

J. Haden Werhan, CPA/PFS, is a partner at Capital Performance Advisors LLP in Walnut Creek, Calif. Haden specializes in advising dental professionals on tax and wealth management strategies. He can be reached at 800-877-0564.

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