From the August 2007 issue of Boomer Market Advisor • Subscribe!

August 1, 2007

Important ruling means big business

The issue I'm about to discuss is critical to you and your business, so this will be the first part of a two-part column. That is, you can cut your clients' tax liability by making proactive recommendations regarding after-tax assets in their retirement account.

First, ask your client if they have any after-tax assets in their retirement plans or IRAs. Then, think about how you can convert to a Roth IRA without having to pay the accompanying tax (this also applies to your clients who make more than $100,000).

Two categories of clients can benefit. They are:

1. Active employees or self-employed individuals with after-tax assets in qualified retirement plans and/or non-deductible IRAs.

2. Retirees who have after-tax dollars in their qualified plan/IRA but are generating some type of earned income.

After-tax funds accumulate in retirement accounts in three ways:

1. Money was contributed to plans prior to mid-1986, when the IRS did not allow a tax deduction for certain retirement plan contributions, but did allow tax-deferred growth.

2. The plan allows employees to contribute additional money to the account beyond the current allowable tax deferred contribution of $20,500 per year.

3. Your client has made - or will make - contributions to nondeductible IRAs (this should be a sizable percentage of your practice). If your clients are maxed out in their retirement plan and make more than $150,000, they should consider nondeductible IRAs so they can later implement the plan I will suggest.

Active employees who qualify for a Roth IRA conversion now (or everyone in 2010) should check to see if their qualified plans allow after-tax dollars and, if so, whether there are any in the account. If yes, will the plan allow them to make withdrawals of the after-tax amounts for reasons other than hardship? Many plans allow active employees to take distributions of after-tax dollars, but not distributions, of pre-tax amounts.

A great idea that's rarely used

This entire strategy is only possible because of a loophole created in 2002, one which was never corrected. I am not alone in recommending this strategy, but it's one very few advisors employ. Though the mechanics may be complicated, it's sound as long as mistakes are not made.

Prior to 2002, removing after-tax assets from tax-deferred vehicles was not in the best interest of most investors. If a participant was to remove the money to invest independently, they would have to pay taxes on the subsequent interest, dividends or capital gains. The fact that no income tax occurred on the distribution was not enough to recommend the strategy. Leaving the money in the qualified plan to grow tax-deferred was the better option. Now, however, the picture is changed. First, the simple case:

Roth IRA conversions for individuals without existing IRAs

Individuals without an IRA may be able to roll the after-tax money from their qualified retirement plan into an IRA. In this instance, the IRA would be funded solely with after-tax contributions. Once this IRA is established, it is then possible to convert it to a Roth IRA for individuals with modified adjusted gross incomes below $100,000. In this example, the only money rolled over is the after-tax portion of the retirement plan. After-tax amounts in an IRA are referred to as its "basis." In this case, the basis of the IRA is equal to its total value (the basis of a traditional IRA is zero). Since taxes have been paid on the full amount of this nondeductible IRA, there will be no additional tax upon conversion to a Roth IRA.

In 2008, after-tax assets in a qualified retirement plan may go directly from the qualified retirement plan to a Roth IRA without having to first establish a traditional IRA. Although the IRS rule is still murky, it appears that even a taxpayer who has an existing IRA qualifies for the free Roth IRA conversion of the after-tax dollars. The real advantage of the rollover and subsequent Roth IRA conversion is that the Roth IRA will grow income tax free, not income tax deferred. Unless there are extenuating circumstances, everyone who qualifies should do it.

Next month we will examine this strategy for clients with existing IRAs and clients who are retired.

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