On January 1, 2010, nearly $1.4 trillion of retirement assets will immediately become eligible for conversion to Roth individual retirement accounts. Under the Tax Increase Prevention and Reconciliation Act of 2005, higher paid individuals will be able to take advantage of an opportunity once limited to taxpayers with an adjusted gross income less than $100,000. (See box.)
The time to start planning for this opportunity is now. Here are some factors to consider:
1. The current market provides a low cost conversion opportunity. The current market may give savvy investors a unique opportunity to gain tax efficiency. Retirement accounts generally grow tax deferred. The investor, or his/her heirs, will eventually have to pay taxes on the value of those accounts. The higher the account value, the more taxes owed. Since many investors have lost 30% to 50% of retirement account value in the last 18 months, now may be a perfect time to recognize the income tax liability.
What if the Roth IRA continues to lose value after conversion? Ask the IRS for a “do over.” A retirement account converted to a Roth IRA can be “recharacterized” back into a traditional IRA with no tax consequences.
In golfing terms, the taxpayer gets to “Take a Mulligan.” It’s relatively straightforward. A Roth IRA can be recharacterized back into a traditional IRA up to the tax filing deadline, plus extensions. So, if one converts a traditional IRA to a Roth IRA in January 2009, the investor will have up to October 15, 2010 to decide whether to take the “do-over.”
2. Hedge against increasing income tax rates. For those who believe income tax rates will eventually increase, now may be the perfect time to convert retirement assets to a Roth IRA.
For decades, the United States had a top marginal tax rate as high as 50%, 70% and 90%. In fact, the 5-year period of 1988-1992 was the only time in the past 50 years when the top marginal tax rate was less than today’s 35%. Considering the current budget deficits and bailout/stimulus costs, many believe income tax rate increases are inevitable. Those sharing that belief may wish to realize taxable income now and take advantage of today’s historically low income tax rates.
3. Gross up the retirement account value. When paying the Roth conversion tax liability, the taxpayer could use either assets from the IRA or outside of the IRA.
Of course, the use of IRA assets means the Roth IRA will have fewer assets to grow tax-free. Furthermore, should the IRA owner be under age 59 1/2 , using IRA assets to pay the conversion tax would result in a 10% early withdrawal penalty. That is why it is often preferred to pay the resulting taxes out of pocket, assuming the taxpayer has sufficient outside assets to do so; this essentially grosses up the value of the IRA.
Example: Assume an IRA owner in the 35% tax bracket has a $100,000 IRA. From purely a federal income tax perspective, that $100,000 IRA would be worth about $65,000 to the taxpayer (since, upon liquidation, the IRS would get 35%, or about $35,000, of the money). But by converting the traditional IRA into a Roth IRA and paying the resulting income tax liability from assets outside of the IRA, the IRA owner grosses up the value of the IRA from $65,000 to $100,000.
4. Tax diversification. Very few investments grow tax-free, other than tax-exempt municipal bonds. The Roth IRA is the exception. There are advantages to having a tax-free Roth account to draw from in retirement. Just as asset allocation and investment diversification are cornerstones of proper financial planning, having tax diversification will become increasingly important, especially during retirement.
By being able to supplement retirement income with tax-free income, retirees increase the likelihood of keeping themselves in a lower income tax bracket.
5. Tax-free stretch. A compelling reason to convert retirement assets to a Roth IRA is to enable IRA beneficiaries to stretch the account tax-free over their lifetime. Similar to traditional IRAs, Roth IRAs allow beneficiaries to stretch the IRA by taking only the minimum required distribution each year over his/her life expectancy. But unlike traditional IRAs, Roth IRAs permit the undistributed amount to continue to be invested and grow tax-free (not just tax deferred) over the beneficiary’s lifetime.
Many people will not be able to convert retirement assets until the adjusted gross income limits are eliminated in 2010. But now is the perfect time to plan for that opportunity. Start by considering the factors that may make conversion beneficial; then identify retirement accounts (especially those that have recently lost value) and start positioning those assets now.
Brandon Buckingham, JD, LLM, is an advanced planning attorney with John Hancock Financial Services, Boston. His e-mail address is: firstname.lastname@example.org