By now, most financial advisors should know about the ability to convert tax-deferred traditional IRA accounts to tax-free Roth IRAs, which became law in the tax reform enacted in 1997. In the tax reform legislated in 2006, the conversion opportunity was extended to high-income earners earning more than $100,000 a year, but does not take effect until 2010.
This opportunity comes as welcome long-term tax planning for some high-income Americans. Discussions should begin now with clients so those who can benefit may start taking steps to take full advantage of this opportunity.
Before going down this road, however, advisors and clients must identify all IRA arrangements. The most important and misunderstood part of the law is the pro rata tax due on the aggregate IRA accounts. If one IRA account contains after-tax money and other accounts have pre-tax money, the accounts are aggregated in computing the tax. So, if a client has made non-deductible IRA contributions and they also have an IRA rollover from a 401(k), they will have to aggregate the accounts. The non-deductible IRA cannot be treated separately. Knowing this, the client may choose to move the rollover IRA back to a 401(k) if eligible.
Other opportunities also exist for clients who can control their income. Here are some different scenarios for clients that may benefit by a 2010 Roth conversion:
- Clients who sell a company in 2009 and may have lower income in 2010. The idea is that the conversion may fall into a lower tax bracket year. Also, the client may structure a settlement for the sale of the company, which may reduce taxes with proper planning.
- Clients who wish to do some estate planning for the next generation. Paying an income tax now may be better than paying additional estate taxes and an income tax later. In addition, clients can structure assets to go to different beneficiaries that are most favorable according to the beneficiary’s current and future tax brackets. For example, for two different beneficiaries: one a doctor earning $300,000 and one a teacher earning $30,000 a year, the Roth IRA can be given to the higher-income beneficiary, with other assets going to the lower-income beneficiary.
- Clients who want to avoid required minimum distributions at age 70 1/2 may consider a Roth conversion.
There are several factors to consider involving current tax brackets and expected future tax brackets for the account holder or the beneficiary. One is the time the money will stay invested. Another is how the taxes will be paid. Taxes are due on the conversion in years 2011 and 2012. And a final consideration is the future political landscape and the impact of the decisions made today.
Given certain known and unknown variables, several questions come into play, particularly if a client has several accounts. Will some money come out tax-free, will some come out taxed, and can that same client perhaps reduce his or her tax brackets down the road? Can the client pay less in federal and state taxes? Can the client reduce the tax obligation on Social Security? Can the client extend the withdrawals after age 70 1/2 ? Can clients improve estate planning for both themselves and their beneficiaries? These are some of the most the critical questions advisors need to start communicating with their clients now in preparation for the conversion process, particularly if it is expected to be a smooth and organized one when it occurs in 2010.
Peter Miralles is the president of Atlanta Wealth Consultants LLC. He can be reached at firstname.lastname@example.org.