Re-Working A Roth PlanSubmitted by Guidant Planning on July 11th, 2009
By Allen Yee
2010 is just around the corner…
The new year presents a planning opportunity one can’t/shouldn’t neglect. In just 6 short months, anyone with a qualified account (IRA,401(k), 403(b), 457, etc.) may convert some or all of those dollars to a tax-free Roth IRA. In 1997, legislation brought about the creation of the
Roth IRA and individuals were permitted to convert their traditional IRA to a Roth IRA. There were two stipulations for that conversion 1) pay the current income taxes resulting from the conversion and 2) be under the income limit. That income limit is $100,000+ of modified adjusted gross income reported on your Federal return. Basically, if you’re making more than $100,000 in gross you cannot convert.
In May of 2006 there was a pretty significant change in the tax law involving conversion to Roth IRAs. For the tax year of 2010, anyone with a qualified account may convert those dollars to a Roth IRA, no matter your current income; however, you must pay the income tax due on the conversion. The provision added a potentially better benefit. For conversions completed in 2010 only, you may divide the converted amount over the subsequent tax years of 2011 and 2012. As an example, if you converted a $100,000 IRA, $50,000 is included in your
2011 income and $50,000 is included in your 2012 income. The taxes on your 2011 income are due April 15, 2012 and the taxes for 2012 are due on April 15, 2013. (Please consider that you may need to make quarterly estimate tax payments so please consult your tax professional.)
It seems like a great deal, doesn’t it? We convert on January 2, 2010, and half of the taxes aren’t due until 28 months later (4/15/2012) and the other half won’t be due for 12 months after that (4/14/2013)! What’s the catch you may be asking? Well, if income tax rates go up significantly, you may end up paying a lot more tax than you originally thought. The current (2009) tax rates are published, but who knows what President Obama and our legislators are going to do with future income taxes? The bottom line is you have an interest free loan provided courtesy of Uncle Sam to fund your conversion.
It gets better! Inside the conversion rules there’s also a provision that allows for a Recharacterization. Basically it’s a do-over! What that means is that if you convert a qualified account to a Roth IRA, you can reverse the transaction. As an example, you convert $100,000 to a Roth IRA, subsequently the market reduces the value to $80,000. Well, we can Recharacterize the Roth IRA back to an IRA. What does this accomplish you ask? Well, we get the taxes we paid for the $100,000 conversion back. We don’t get any of the market value loss, but consider what we paid for the conversion on the Roth. If we converted a qualified account to a Roth, the tax due on a $100,000 (25% bracket) conversion would be $25,000. If the account declines to $80,000 we would owe less taxes (same bracket), a savings of $5,000. So we simply Recharacterize before October 15th of the year following the conversion.
So what should you do now? Get started on all the leg work; don’t wait for 2010 to come around. It may be more advantageous to convert some of your qualified accounts today, assuming you’re under the income limit. If you’re over, it’s still better to formulate a plan now rather than to wait for the beginning of the year. Organization of qualified accounts can help in the design of the conversion, so do it now. For further information, or questions regarding topics discussed in this article please call (626)396-1650.