The Roth IRA Conversion--Giving Away The Farm

First, any sharp account declines within the year of the conversion may result in buyer’s remorse, as the investor realizes he or she bought into the farm just before it went on sale, and ended up paying taxes on the higher account value.

Second, tax rules are subject to tax laws imposed by the government. There is no guarantee that a conversion made now will still make sense several years down the road due to changes in factors such as tax rates.

Third, to reap the greatest long-term benefits, accounts must remain untapped throughout the wealth transfer process. Investors should be certain that they will not need significant income from their accounts, and should also be secure in the fact that their heirs will limit their distributions to the inherited IRA rules.

If each of the above conditions is met, then using a Roth IRA to create a tax-free account for one’s heirs becomes very attractive. If clients intend to avoid using a restrictive document such as a trust or other restricted account, consider whether their heirs will leave the account intact, so that the fruits of their labor and the dues paid upfront will be distributed as efficiently as possible between generations.

It’s also important to be aware of the rules respecting distributions from a Roth IRA that has been converted. Qualified distributions made from such a conversion are typically tax- and penalty-free, provided that all the rules are satisfied. In order to meet qualified distribution rules, the following requirements must be met:

The Tax Technical Corrections Act of 1998 (TTCA) establishes a 10% penalty on specific conversion assets if accessed during the 5-year holding period that begins with the year in which the conversion contribution was made. It is important to note that separate 5-year periods apply for each conversion that is completed in separate tax years. In addition, the Roth IRA holder is exempt from the penalty if he or she has attained other qualifying events, such as attaining the age of 59 1/2 , becoming disabled or taking part in a 72(t) program. Other qualifying events include using the funds for higher education, the purchase of a first home, or qualified expenses related to health or medical expenses.

Oops!

Imagine that your client has done a conversion and has inadvertently exceeded MAGI limits or experienced sharp declines in account value. Fortunately, a “do-over” is permissible; the client can perform what is referred to as a recharacterization.

A proper recharacterization may be done up to the legal due date of one’s tax return, including extensions. For example, if clients converted to a Roth in 2008, they potentially have until October of 2009 to recharacterize. If they file without extensions, they will need to file amended returns. When filing with an extension for 2008, they can simply report this recharacterization when they file and all associated tax liabilities should be removed.

Who should consider

If a client is weighing a Roth conversion, one of the first things to consider is where interest rates are headed. If current tax laws favor the client and the client falls under the conversion MAGI limits, it may be a good time to convert to a Roth IRA.

Let’s assume the client’s primary intention is to leave retirement funds to heirs, including a spouse, and that the client has disposable income that allows for a conversion without depleting convertible assets. If the client falls under MAGI limits, he or she could begin systematically converting now and spread out tax liabilities.

A client who is restricted under AGI limit rules can wait and convert in 2010. Most importantly, there is no RMD requirement for Roth IRAs, and no tax when the funds are accessed after 5 years and a qualifier is met, such as after death when the client is leaving funds to heirs, which is much easier to do when one isn’t forced to access the account.

Finally, don’t forget about other Roth rules. Non-spouse beneficiaries can now directly roll inherited assets out of qualified plans and convert them during the rollover process to an inherited Roth IRA. If the account performs poorly and drops in value, a possible conversion allows the client to pay taxes early and wait out a tax-free value increase over the years the client stretches out those inherited funds. (Note: MAGI limits still apply.)

As always, it’s important to remember that every individual’s financial situation is different, and the suggestions outlined here may not apply now or in the future to the client’s retirement or estate plan. Consider all aspects appropriately, as there has never been more to know.