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Financial Planning > Tax Planning

As 2010 nears, clients eye Roth conversions

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Many clients are already looking ahead to 2010 when two much ballyhooed tax law changes concerning traditional-to-Roth individual retirement account conversions will occur.

These are the removal of the current income cap; and the ability to defer payment of income tax.

“Many people would like to do a Roth conversion because of the favorable income tax treatment on distributions,” says Daniel Cordoba, CEO of Asset Exchange Strategies, LLC, Austin, Tex., and founder of the National Association of Tax Favorable Investing.

“There’s an expectation that tax rates in the future will be higher. For clients concerned about paying excessive taxes later on, a Roth can be a good hedging strategy.”

How so? While funds invested in a traditional IRA grow tax-deferred, distributions from a Roth IRA are income tax-free once clients are eligible to begin taking withdrawals at age of 59 1/2 and after the owner has held the Roth for five years.

Also to be considered, however, is the tax treatment of account contributions. Funds contributed to a traditional IRA are income tax-deductible; Roth IRA account holders do not enjoy the same advantage.

Many high-wage earners, sources say, are now expressing interest in doing a traditional-to-Roth conversion because of the lifting of the $100,000 modified adjusted gross income limit on such conversions in 2010. Those who earn less than the $100,000 cap can convert now–and they may want to do so. Given still depressed equity prices, clients may pay less income tax on an IRA account value that stands to grow with market appreciation, experts point out.

Clients who do convert in 2010 can defer recognizing of income over the next two years. The IRS thus will allow individuals to pay 50% of the tax on conversion in 2011 and the balance in 2012.

For individuals at or near retirement, a key issue is the impact of a conversion on income planning. The transaction may or may not make sense, sources say, depending on whether the client intends to draw down the account or keep funds invested.

“A traditional-to-Roth IRA conversion should be considered by clients who don’t need to tap retirement assets immediately,” says Gary Tenpenny, a senior financial planner for Mid American Financial Group, Overland Park, Kan. “By keeping the money in the account, clients will achieve greater flexibility in later years when they do need to draw on additional income sources.

“A conversion will be optimal for people who are between five and 10 years of retirement,” he adds. “They can let the time value of money [invested] go to work for them.”

Considerations include: the client’s ability to pay the income tax on the conversion over the two years allotted, how the tax is to be paid, the size of the account to be converted and the diversification strategy to be adopted.

The tax on the conversion, says Tenpenny, should be paid from sources other than the IRA to maximize the benefit of the Roth’s favorable tax treatment. If the traditional IRA account is small, adds Cordoba, doing a conversion may not make a difference because the client doesn’t stand to gain tax-wise.

A conversion may also not be worthwhile, Cordoba says, if the plan is to invest in assets–mutual funds, bonds and money market funds–that currently yield low investment returns.

Clients stand a better chance of realizing income planning objectives (including recouping the loss resulting from the tax paid) if they invest in higher-yielding assets offered through self-directed IRAs, he indicates. Among other vehicles, these retirement accounts permit investing in real estate, stocks, mortgages, franchises, partnership, private equity funds and tax liens.

Cordoba notes, however, that the yields enjoyed by clients often depend as much on the mindset of the account holder as on the relative investment advantages of different IRAs. Of the three client types he serves–W2 wage-earner, “intrapreneurs” (corporate executives) and entrepreneurs–the last almost always come out ahead.

“Entrepreneurs know how to readily convert $10 to $100,” he says. “Executives who think outside the box can, over time, turn that $10 into $100. The W2 wage earner tends to go with a status quo methodology, growing the $10 to $20.”

For those clients who are eligible, doing a Roth conversion now may be better than waiting until 2010, according to industry experts. Given the prospect of a rise in tax brackets to address a ballooning federal budget deficit and national debt, many clients may deem it advisable to “accelerate” (recognize more) income in the current tax year and defer expenses into later years–the reverse of the traditional approach.

Assuming a rise in tax rates, it thus may be prudent to take an income tax hit now, says Herb Daroff, a certified financial planner and partner at Baystate Financial Planning, LLC, Boston, Mass. Otherwise, the client risks paying higher income tax in future years, offsetting any gain from the conversion.

Todd McDonald, a principal of Broadstone Advisors, Albany, N.Y., agrees that a conversion in 2010 may be disadvantageous, adding that factors apart from a rise in federal income tax rates could force the client to pay more in tax.

“If, say, a company employee recognizes additional income next year by exercising stock options, and this transaction coincides with a Roth IRA conversion, the employee could end up paying higher income tax on the conversion,” he says.”Why add income that could potentially put you in a higher tax bracket?”

Given future tax uncertainties, he adds, the wise course may to convert part of a traditional IRA to a Roth, such a quarter or a third of the account value. This investor can thereby secure tax diversification among different retirement accounts.


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