From the November 2008 issue of Boomer Market Advisor • Subscribe!

Baby boomer rollover readiness

How to capitalize on the opportunities -- and dodge the landmines -- buried in IRA rollover rules.

High-powered spectacles and a strong espresso aren't prerequisites to one of David Littell's courses at the American College, but they sure do come in handy. When it comes to IRA rollover rules and federal tax laws like the Pension Protection Act of 2006, Littell covers all the nitty-gritty details.

As enticing and potentially rewarding as some of the IRA provisions in the two-year-old PPA are, capitalizing on the opportunities created by those provisions requires a thorough grasp of the law's often complex and nuanced -- and sometimes vague -- language, says Littell, an attorney and professor of taxation at the American College. So advisors who enroll in Littell's courses can expect to spend plenty of time on IRA minutia.

"I really give them a lot of detail. I bust them over these issues," Littell says. "If you're going to be competing for IRA rollover dollars, you have no business doing that unless you know the rules. It's easy to get the rules wrong, which means it's easy to create tax problems for clients. So it's really critical for advisors to know this stuff backward and forward."

What exactly is this "stuff"? Let's look at some of the post-PPA IRA rollover maneuvers and techniques with which retirement planning specialists recommend advisors familiarize themselves:

Inherit the ability to stretch: non-spousal rollovers. The PPA created a vital new estate planning tool by allowing a non-spouse beneficiary such as a child or grandchild who inherits assets in a 401(k), Section 457, 403(b) or other type of qualified plan to transfer the balance in that plan directly to a an inherited IRA, and then to opt to stretch distributions from that IRA over a lifetime.

The non-spousal provisions also apply to transfers where a trust is named as beneficiary, notes Joel Javer, CLU, CFP, principal at Sharkey, Howes & Javer, a financial management firm in Denver, Colo., provided the trust meets IRS requirements. The inherited IRA receives the transfer and dispenses required minimum distributions to the trust. Be sure to revisit existing trusts to ensure they can legally accommodate such a maneuver, he says.

Littell calls the non-spousal provision "really important" because it allows a beneficiary to leave money in the inherited IRA and stretch distributions over a period of time instead of having to take a large distribution that's taxed as a lump sum. Such a payout might even push the beneficiary to a higher tax-bracket. "From a planning perspective," he explains, "the key here is to protect your opportunities to get maximum income tax deferral for as long as possible."

There are several potential landmines in the non-spousal rollover rules that advisors need to be wary of, lest the tax-deferral benefits be lost. The transfer must be executed as a direct trustee-to-trustee transfer, for example. The beneficiary actually never gains custody of the inherited funds because they go directly into a properly titled inherited IRA. If a check is issued directly to the non-spouse beneficiary in his or her name, or if funds are mistakenly transferred into another type of retirement account, the transfer amount may be treated as an immediately taxable distribution. Further, to take advantage of the "stretch" opportunity, says Littell, lifetime distributions from the inherited IRA have to begin sometime during the year following the year of the plan holder's death.

One step instead of two: direct conversion of a qualified plan to a Roth IRA. Roth IRAs have been around for more than a decade, but it wasn't until implementation of the PPA that owners of qualified 401(k), 403(b) and 457 plans could convert their retirement accounts directly into a Roth IRA, without exposing the amount of the conversion to a 10-percent early withdrawal tax, instead of first having to roll those accounts into a traditional IRA, as had been required under previous law. The PPA eliminated the extra step, which, if nothing else, spares advisors and their clients the hassle of extra paperwork and the potential for a misstep in the conversion.

To execute such a maneuver, the taxpayer is required to include the distribution in taxable income (unless it involves distribution of after-tax funds). At least for 2008 and 2009, the existing income cap applies, so only taxpayers with gross income of less than $100,000 are eligible for the Roth conversion.

Such a conversion can also create a tax loophole that could be worth exploiting. If a specific plan allows a partial distribution of only after-tax funds, there's an opportunity to convert those funds tax-free, circumventing the pro-rata rule that typically applies to after-tax IRA distributions. In cases where a plan issues separate checks for pre-tax and after-tax funds, the pre-tax funds can be rolled into a traditional IRA and the after-tax funds can be converted directly to a Roth IRA, tax free, without the pro-rata rule applying.

The cap comes off in 2010 (maybe): Elimination of the income limit on conversions to Roth IRAs. Among all the IRA rule changes to come along in recent years, the one that many IRA specialists see as potentially the most valuable might never survive to be implemented. As the law is currently written, the $100,000 income cap that limits eligibility for conversions from traditional IRAs to Roth IRAs will disappear in 2010 so that anyone can convert to a Roth, regardless of income level. The income eligibility requirements for contributing to a new Roth IRA remain in place at $110,000 for a single person and $160,000 for married couples. But lifting the existing $100,000 conversion cap allows high-income clients to bypass those limits simply by investing in a non-deductible IRA, then converting it to a Roth.

"It's potentially a great planning technique, especially for higher-income people who have been setting aside money in nonqualified IRAs," says IRA rollover expert Dorann A. Hurley, RIA, principal at Hurley Financial LLC in Corvallis, Ore.

The provision comes with a big "if," however. If, in light of this fall's financial crisis and the mounting federal deficit, the U.S. Congress starts repealing tax breaks, then the 2010 cap-removal provision is highly susceptible to revocation, observers say. So high-income investors who start making non-deductible contributions to a traditional IRA with the express intent of converting that account to a Roth, based on the assumption that the provision will survive, are rolling the dice that Congress will leave the loophole intact.

If the provision does survive, its value as an estate-planning tool should not be underestimated, he says. Essentially what it allows the account holder to do in making the conversion is to pre-pay estate taxes and thus, to lower their taxable estate. "It could be a money-making machine to heirs. Someone can leave [the Roth] to their kids, who can choose to take distributions from it over their lifetimes. So they get additional tax-free growth and a tremendous stream of tax-free income that can go on and on."

A few key things to keep in mind if and when the provision takes hold -- there's also a one-time opportunity to spread payment of conversion taxes over the 2011 and 2012 tax years, instead of paying them in lump sum. Also, in making such a conversion, the account holder doesn't have discretion as to which portion of traditional IRA money is converted. In other words, account holders cannot selectively convert just nondeductible contributions into a Roth IRA. Instead, upon conversion, the account owner will incur income taxes (on a pro rata basis) on all deductible contribution amounts across all of his or her IRAs, and on any growth in the account(s).

Thus, to capitalize on elimination of the cap, the experts suggest making nondeductible contributions to a traditional IRA in advance of the cap being lifted in 2010, particularly in cases where the client has little or no existing deductible IRA balance to complicate matters.

Early access, no penalty: the IRA education exception. Only in rare circumstances does Littell recommend someone take early distributions from an IRA. But in cases where a client unequivocally needs funds (such as to finance a business start-up, for example), he or she could benefit from a rule that allows money to be withdrawn from an IRA before age 59-and-a-half, without the typical 10-percent penalty, provided the account holder also is incurring qualified expenses for higher education, such as tuition costs for a child (or even a spouse) to attend college. While the early distribution may be subject to income tax, it generally won't be subject to the additional 10-percent tax, provided the distribution amount doesn't exceed the amount of the person's adjusted qualified education expenses for the year.

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