Tax policy in Washington is headed for big change. You can add great value to your practice by staying informed about policy changes and keeping your clients educated.
Much of the anticipated change will be in the form of higher income tax rates, but there is some good news and some great opportunity for our clients emerging from the turmoil.
One such area of promise is in Roth conversion opportunity for 2010. As the $100,000 AGI limitation for Roth conversions will be temporarily repealed, our higher income clients will be allowed to entertain the option of converting regular IRA dollars to Roth IRA dollars, a strategy that was not available to this group in the past. Of course, taxes on the original IRA money must be paid in the year of conversion, but there are still benefits worth pursuing.
In general, the massive loss of investment market value has resulted in reductions of retirement plan and IRA assets for everyone. As account values plummet, the prospect of a Roth conversion for clients that qualify becomes more valuable, as the client’s potential current tax liability is reduced.
In fact, if you service clients who converted IRAs during 2008, you may want to revisit the transaction in order to analyze whether or not it would make financial sense to re-characterize the conversion, then, do it over based on the lower 2009 account values. Under IRS Reg. 301.9100-2(b), there is a provision that allows for an automatic six-month extension as long as the client filed their return on time (by April 15).
For clients who are still working and hold IRA accounts containing both pre-tax and after-tax balances, you can potentially roll over the pre-tax assets and combine these assets with the balance in an employer-sponsored savings plan. This strategy will serve to isolate the after-tax dollars in the client’s IRA allowing for a subsequent conversion to a Roth IRA with no tax liability. Post-conversion, this money continues to grow in a tax deferred environment, avoids required minimum distribution requirements and ultimately will be distributed tax-free during retirement as long as the account is held for five years or beyond age 59 ½, whichever is longer. This strategy will also serve to avoid the exclusion ratio calculations for an IRA account with pre- and post-tax balances.
The conversion question is driven by many factors, but ultimately boils down to taxes, and whether or not the client is in a lower bracket during his/her retirement years. Clients who have solely made non-deductible IRA contributions over the working years are obvious candidates for this strategy, especially as income tax rates are most likely on the rise. It is not unrealistic to expect to see income from retirees’ traditional retirement savings accounts suffer equal, or even greater, taxation than applied to income while in the workforce.
The rules will always change, and we’ve already seen some action with the new administration. The changes affect different people in different ways and it is up to you to advise your clients on strategy. For some clients, the certainty of taking on the tax exposure now is appealing, such as those who may have the objective of leaving the assets to their heirs. A Roth IRA is a much more attractive asset to leave behind than a traditional IRA. Although beneficiaries are required to begin distributions on inherited Roth accounts based on their own life expectancies, the additional tax free build up of the Roth over time can be a huge plus. Additionally, tax-free Roth income has a positive effect on Social Security income taxation as well.
Roth conversions create control and options for the account holder. The current $250,000 income threshold established by the Obama administration might very well change in the future so, therefore, a client can do a partial
Roth conversion now, understand and absorb the immediate tax liability, and retain a portion of the account to potentially convert at a later date if the rules change again. Additionally, one can then invest those converted Roth dollars in an annuity and take a lifetime withdrawal benefit, based on a joint life expectancy. The result is a lifetime stream of tax free income and a client with peace-of-mind.
Mark A. Cortazzo, CFP is senior partner with MACRO Consulting Group in Parsippany, N.J.