Roths Now Make the Tax Code Your Friend!

By Bert Whitehead, MBA, JD
Franklin, MI
http://www.bertwhitehead.com/

Here are some points to ponder and strategies to consider. Again, these can be complicated so you should expect to discuss whether these apply to you during the year when you do tax planning with your ACA advisor (i.e. a member of the Alliance of Cambridge Advisors).

#1: Got negative tax? A Roth conversion creates taxable income because of the IRA distribution that funds the Roth, so it certainly is advantageous to convert whatever amount you can if you have negative taxable income. It’s an opportunity to declare income and pay no income tax.

#2: Defer taxes…again! There is a quirk in the law for 2010 that lets you choose to either pay taxes on the 2010 conversion as 2010 income, or pay half the taxes of the 2010 conversion in 2011 and the other half in 2012. There is no interest or penalty to doing the latter, so it would generally be a good option.

#3: Automatic extension. If you are unsure whether your tax rate will be increased in 2011, you can convert to a Roth in 2010 and then file an automatic extension in 2011 so you don’t have to file until October 15, 2011. Then you may know whether your tax bracket has increased or not. If your bracket is being increased you can elect to pay taxes at the 2010 rate.

#4: How much to convert? If you aren’t sure how much to convert, keep in mind that you must make the 2010 conversion before 12/31/2010. However if you convert too much, you can elect to ‘recharacterize’ part or all of your conversion up until you file your 2010 return (i.e. until 10/15/2011) and put it back in your IRA without penalty. So you should always covert too much rather than too little!

#5: In-kind. When converting an IRA to a Roth, you can transfer your IRA investments ‘in kind’ to the Roth without having to sell them and buy them back. If you have a broker, make sure you let him or her know that you know that you don’t have to “sell” (pay a commission”) to convert.

#6: Outfoxing Mr. Market. If the investments drop after you convert them, you still must pay taxes on the value of the holding when converted. How do you preserve the value of the investments that you converted? For many clients, we are setting up 2 Roth IRA accounts: one for bonds and one for equities. We will transfer the full amount to be converted to each Roth IRA, using Stripped Treasuries to go into the bond Roth, and stocks or equity mutual funds into the stock Roth. Then in October of 2011, if stocks have dropped, we will recharacterize that account back to an IRA and do likewise with the bond account if stocks rise.

#7: Asset Location. To optimize ‘asset location,’ Roth investments should be in assets with the highest potential returns, such as small cap or international mutual funds. If using #6 above, and the stocks are recharacterized back to the regular IRA, they should be sold to buy back the bonds and the bonds in the remaining Roth account should be sold to buy back the stocks.

#8: Efficient cash flow. Long-term tax management and tax efficient cash-flow strategies are enabled through the use of Roths. Since there are no minimum required distributions for Roths, taxable distributions are reduced and Roth distributions can be used to maintain cash flow while keeping taxes low in retirement.

#9: Coordinate with charitable contributions using Donor Advised Funds. If you intend to include charities in your will, consider gifting stock now to your Donor Advised Fund in about the same amount that you are converting to your Roth. The tax deduction for the charitable contribution can then offset most of the additional amount of taxes due to the Roth conversion.

#10: The Next Generation. This is an unprecedented opportunity for intergenerational planning. The beneficiaries (spouse, children, etc.) of Roth accounts have the same advantages of taking tax-free withdrawals. If you don’t need the IRA money during your lifetime consider the benefits of not paying income taxes on many years of compounded investment growth.

#11: Reduce onerous estate taxes. Using assets to pay income taxes now reduces your estate for estate tax planning and provides a way you can pay the future income taxes for your children or grandchildren now. (note: as of the date of this blog there is no estate tax. Rules are in flux but it’s a good bet that they’ll return in the future.)

Although it may be obvious, note that Roth conversions also appeal to the federal government because they can tax your pre-tax IRA money now, rather than in 20 or 30 years! But that’s why it’s important to at least review the above points to see how the current legislation affects you. Since your ACA Advisor knows your comprehensive financial plan more intimately than anyone, there may be even more points and issues to discuss.

Be sure to look at these ways to make the Taxman your friend in 2010!

I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.