You may already be aware that Congress is ready to give away the farm, at least as it relates to the Roth conversion. As a result, there has never been a better time to look at utilizing the Roth IRA as both a retirement and estate-planning tool. The Roth conversion process has become more streamlined recently. There are also fewer restrictions than in the past, thanks to the Tax Increase Prevention and Reconciliation Act of 2005.
Beginning in 2010, TIPRA will eliminate the $100,000 modified adjusted gross income (MAGI) limit that currently restricts those who can convert from a traditional IRA to a Roth IRA. Under TIPRA, income generated as a result of a Roth conversion can be reported ratably over years 2011 and 2012.
The Roth IRA is widely known as a tax-friendly vehicle for retirement. However, because we get caught up in the tax-friendly savings aspect of the Roth IRA, we tend to overlook the fact that it also offers a great way to effectively leave money to heirs while lowering one’s estate tax burden.
With the traditional IRA, individuals may receive a tax deduction for annual contributions, which allows the account to grow tax-deferred for an extended period of time. The drawback, of course, is that when retired individuals begin withdrawing money from the account, they must then pay taxes on any amounts withdrawn.
With the Roth IRA, investors do not receive a tax deduction on their contributions, so they are essentially making contributions with after-tax money. As such, the account will grow tax-free. Furthermore, as long as certain qualifiers are met, no taxes are due when an individual begins withdrawing funds at retirement because the taxes were already deducted when the contributions were made.
Perhaps even more important, the individual’s spouse and/or heirs will not have to pay taxes upon inheriting these funds. Standard inherited-IRA rules still apply, but as long as the 5-year holding period had been met by the decedent, the funds can be accessed free and clear.
What are the effects?
So why would it make sense for the holder of a traditional IRA to convert funds to a Roth IRA?
First, consider the surviving spouse. A Roth IRA has no required minimum distribution (RMD) requirement. If a surviving spouse inherits the Roth account, he or she need not take any minimum withdrawals. Conversely, with a traditional IRA, a surviving spouse who takes over the IRA must begin taking taxable withdrawals from the account no later than one year after reaching age 70 1/2 , thereby losing out on the chance to continue to compound the account without paying taxes. Thus, use of the Roth IRA allows for an easy transition from surviving spouse to secondary beneficiaries, such as children.
Another long-term effect of converting to a Roth IRA is the reduction of one’s taxable estate by the amount of income tax paid upon any conversion, which can greatly reduce the estate tax burden for heirs. Consider the following scenario:
Dan owns a traditional IRA worth $500,000, and he’s turning 70 1/2 this year. He already receives a decent pension and his primary intent is to leave these funds to his children. Dan also intends to convert this account to a Roth IRA.
IRS code requires that Dan take a taxable RMD of approximately 3.65% for 2008, which equates to about $18,250. As the RMD phase begins, he will begin depleting his qualified accounts and paying taxes on the distributions. This potentially leaves less money for Dan’s spouse or children to inherit.
Furthermore, because it’s considered part of his modified adjusted gross income (MAGI), the RMD can also affect taxation of his Social Security benefits. In addition, according to Publication 590, if Dan fails to convert before the year he turns 70 1/2 , he is required to take his initial RMD during that year and loses out on the potential tax-free growth of the portion he was forced to withdraw.
Risks and rules
For conversion-related retirement and estate planning strategies to be effective, several factors must be taken into consideration.
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.
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.