2011 and 2012 may be good years to consider conversions for tax, retirement and estate planning benefits
As the U.S. economy continues its sluggish recovery, and despite the turbulence and uncertainty of the global economy, there's a tremendous planning opportunity for many of our clients in 2011 and 2012. Since last year, the income limitations that had previously prohibited many investors from converting their traditional individual retirement accounts to Roth IRAs were removed. Now, virtually anyone, no matter what his income, can convert a traditional IRA into a Roth IRA and potentially receive tax-free distributions in retirement (based on an appropriate holding period and age).
Leading up to the income limitation changes in January 2010, many financial planners anticipated a boom in Roth conversions, but because of the uncertainty with tax rates that would have expired at the end of 2010, many investors remained on the sidelines. With the passage of The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (2010 Tax Act), which extended the existing income, capital gains and dividend tax rates through 2012, investors finally received the clarity they needed.
Deciding when to convert and paying the subsequent tax bill were huge obstacles to conversion last year. An investor must pay the conversion bill based on the current tax rates in effect during that tax year. In 2010, investors had a choice to either pay 100 percent of the tax bill in 2011 based on 2010 tax rates or split the tax liability and pay 50 percent based on 2011 rates and 50 percent based on 2012 rates. Thus, many investors were afraid that when it came time to pay the tax bill on conversion, their income tax rates would be higher and they would have to pay taxes based on the higher tax bracket.
Now that we know tax rates will remain at their lowest until 2013 and as the burgeoning deficit increasingly signals that taxes must eventually rise, this two-year window (or the year and one-half that's left) may be the best time for many of our clients to convert.
Despite its benefits, a Roth IRA conversion isn't for everyone. There are several factors to keep in mind when helping a client decide whether to convert to a Roth IRA.
First, the taxation of pre-tax amounts due when converting from a traditional to a Roth IRA may discourage many clients from converting. When converting a traditional IRA account to a Roth IRA, the holder must pay taxes on any pre-tax amount being converted. This doesn't have to be an all-or-nothing arrangement. In other words, an individual may convert as much or as little of his traditional IRA account to a Roth IRA and only pay a portion of the tax based on the amount converted. In this way, the client can receive the benefits of a Roth IRA according to his tax tolerance.
Pay from non-IRA assets
When the tax bill is due on conversion, it's often best to pay the taxes from non-IRA assets. Taking a distribution from an IRA account to pay taxes (or for other reasons) may result in taxation of that amount as well as a 10 percent penalty if the holder is under age 59½. In most circumstances, whether the client has outside assets to pay the conversion taxes is often the deciding factor for converting.
The aggregation rule
Suppose a client has a traditional IRA with pre-tax contributions and an IRA account with post-tax contributions. The Internal Revenue Service looks at all traditional IRAs as one account when determining contributions and conversions so it's not possible to “cherry pick” among IRA accounts and convert the amount that wouldn't be subject to tax. Traditional IRA account balances are aggregated so the amount converted will include a prorated portion of taxable and nontaxable money.
For many high-net-worth clients with considerable traditional IRA or qualified plan accounts, a Roth IRA conversion could have tax benefits. First, Roth IRA owners may be able to withdraw qualified tax-free distributions, as long as the holder is age 59½ or older and has held the Roth IRA account for five years. The tax-free distributions from a Roth IRA could prove extremely beneficial in a rising tax environment and can serve as a hedge against higher taxes.
In addition, a Roth IRA provides flexibility. Unlike a traditional IRA, which requires that the holder begin taking required minimum distributions (RMDs) by age 70½, the holder never has to take an RMD from a Roth IRA account. This means that if the holder so chooses, the Roth IRA can remain untouched and grow tax-deferred for the benefit of the next generation.
As previously stated, a Roth IRA provides potential tax-free income in retirement. This becomes increasingly relevant as companies continue to freeze or eliminate pensions for employees. In addition, as Congress battles over spending cuts and tax increases to manage and reduce the federal deficit, entitlement reform will likely be a key issue. A plan recently developed by House Budget Committee Chairman Paul Ryan (R-Wisc.) proposes major changes to Medicare and could significantly reduce benefits for post-age 65 individuals now under age 55. Other deficit reductions plans have included suggestions for reform, including cuts proposed by President Obama. Many Democrats who had previously balked at any mention of entitlement reform or reduction of benefits have now shifted their support to making specific adjustments to entitlements in an effort to preserve the benefits for future generations. As the debate continues, it has become clear that the enormous costs of funding Social Security, the demographic shifts that will likely occur in the near future resulting in fewer workers paying into the system versus individuals drawing benefits and the effects that the deep recession has left on the Social Security Trust all indicate that this is the elephant in the room that must be addressed sooner rather than later.
Thus, it's becoming increasingly clear that traditional retirement planning is changing; there's less reliance on companies and the government for funding our retirement and more individual responsibility to save and plan accordingly.
Since continuing contributions to a Roth IRA are still subject to income limitations and are also limited to $5,000 per year ($6,000 for individuals age 50 and up), this won't be an individual's main retirement vehicle. However, in an era of rising taxes, the ability to tuck away wealth in a tax-deferred account via conversion well into an individual's retirement years without having to take a distribution alleviates the tax burden and provides a potential income tax-free legacy for the next generation. For wealthy clients in a high tax bracket, the ability to maintain a large chunk of wealth in a tax-deferred account is invaluable and when the holder — or his beneficiaries — makes withdrawals, these distributions will likely be tax-free. For the right client, this is a win-win situation.
A Roth IRA also provides the advantage of flexibility in retirement. That is, if the client so chooses, he may turn on and off income according to his need, tax bracket and other retirement assets. For example, a client in his 60s, who's still working or in a high tax bracket but needs supplemental income could start drawing the tax-free distributions from the Roth IRA during that decade. The remaining account will continue to be invested in the market and grow tax-deferred. The holder may make a withdrawal when needed without worrying about the tax consequences. In addition, Roth distributions won't be subject to the 3.8 percent Medicare tax that's set to be imposed on most investment income in 2013. This additional tax will apply to families who make $250,000 or more or single filers who make $200,000 or more. Furthermore, Roth IRA distributions won't be allocated as income that would subject any Social Security distribution to be taxed.
In the same example, the holder may continue taking withdrawals from the Roth IRA account during his 60s and at age 70 (when he's presumably in a lower tax bracket) or he may choose to begin drawing Social Security benefits instead and stop withdrawing from the Roth IRA. On the other hand, the holder could choose to never take an RMD from the Roth IRA and leave it for the next generation.
Although paying taxes now to convert a large asset or account may be perceived as unwise, the future tax benefits of such a strategy may outweigh the short-term negative effects. Converting to a Roth IRA can help to decrease, hedge and diversify assets and may provide flexibility in tax planning down the road. In general, clients in their 30s and 40s with a long-term retirement horizon may be good candidates for a Roth IRA conversion. Clients in their 50s who plan to continue working until at least age 65 may also benefit since the Roth IRA will potentially allow them tax-free distributions while they're still working and would also give them the flexibility to wait to begin receiving Social Security benefits and distributions from retirement and qualified plans at a later age (although mandatory distributions must begin at age 70½). In addition, wealthy clients who don't need income but want to leave a legacy and reduce their estate should also consider a Roth IRA conversion.
Because qualified withdrawals from a Roth IRA may be tax-free to the holder and beneficiaries, in a rising tax environment this benefit is crucial. It allows the holder tax diversification so that as he's drawing down from his retirement and Social Security accounts, his tax liability may be reduced because he's receiving a mixture of taxable and tax-free withdrawals. Especially as ordinary income tax rates increase, the tax-free distributions from a Roth IRA can act as a hedge against taxes.
High-net-worth individuals may also benefit from a Roth IRA conversion because it provides tax-free distributions to their families. Once the Roth IRA account owner dies, the non-spouse beneficiaries must begin to take withdrawals from the account, but the withdrawals will likely be tax-free distributions from the Roth IRA account. In addition, if the family so chooses, they may be able to take their distributions as a “stretch,” which would keep the account invested in the market and growing, while providing on-going lifetime tax-free distributions to the beneficiaries.
Thanks to the 2010 Tax Act, estate planners and wealthy clients now have more incentive to plan or make large gifts before 2013, to establish trusts funded with substantial assets and to take advantage of strategies that help to minimize taxes. For estate planning purposes, a Roth IRA conversion could provide tax savings for both the holder and beneficiaries and may be an effective way to turn a tax-generating asset into a tax-free legacy.
In cases in which life insurance isn't an option for the holder, but the holder also wishes to maximize the amount of wealth he passes on to the next generation, a Roth IRA account can be held for the purposes of legacy planning. When the holder passes away, the beneficiaries, most likely the children, may potentially receive the distributions tax-free.
One simple way to ensure that each family member receives an equal portion of the account and to allow for flexibility is to create several Roth IRA accounts and name each child as a specific beneficiary for each account. Caution: Some IRA custodians won't allow several IRAs of the same type to have different beneficiaries.
In this way, beneficiaries may indicate how they wish to receive the distributions — as a lump sum, distributions or a stretch payment over their lifetime.
In addition, a Roth IRA conversion could help to reduce a large estate and thus reduce the potential estate tax liability. Because the bulk of an individual's wealth is usually held in an IRA or qualified plan, one way to reduce the tax burden is to convert all or a portion of the IRA account into a Roth IRA. This will likely result in a substantial tax bill which should be paid using outside assets. The holder may liquidate assets within the estate to pay the conversion taxes, thus reducing the estate and removing subsequent estate tax liability. So instead of burdening the beneficiaries with paying estate taxes on an IRA or qualified asset, the conversion taxes are already paid and the holder may leave a tax-free legacy.
Lena Rizkallah is an attorney and principal at Mosaic Consulting in New York City