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Alan Haft
Alan Haft
 

Brad and Angelina or 2010 and ROTH

Which is more attractive?

January 19, 2010
by Alan Haft

While at first the answer might seem simple, by reading on you’ll quickly see why it’s most likely not.

Let’s take a quick step back and recap the Roth. While I’m sure for most this is a bit basic, sometimes the busy days get the best of us so I figured I’d start off by quickly refreshing your memory.

Thanks to the late Senator William Roth (R-DE) leading the charge in 1998, Congress gave us American taxpayers that precious gift known as the Roth IRA. The quickest way to describe a Roth is to compare it with the more familiar traditional individual retirement account (IRA). Some basic points summarized as follows:

  TRADITIONAL IRA ROTH IRA
Deductible contributions? Yes No
Taxation during growth No No
Withdrawals Taxable Tax-Free
Contributions age limit? Yes No
Required Distributions? Yes No

Of course, some of the above are subject to certain conditions and restrictions, but for the moment, I’m trying to keep this simple. For example, subject to various exceptions, withdrawals from a Roth are tax-free only when taken after the greater of five years from the time the contribution or conversion was first made or when the client making the contribution or conversion turns 59½, otherwise, penalties and taxation can apply.

While the above may sound well and good, not everyone can contribute into a Roth. For example, in tax year 2010 a client cannot make a contribution if their Modified Adjusted Gross Income (MAGI) exceeds the following amounts:

  1. For taxpayers filing single or head of household: $120,000
  2. Married filing jointly: $177,000
  3. Married filing separately: $10,000

In addition, if a client qualifies for a Roth, there are limits to the amounts that can be contributed. For tax year 2010, a client can contribute up to $5,000 and an additional “catch-up” contribution of $1,000 if they are over the age of 50.

Furthermore, as long as a client’s modified adjusted income is lower than $100,000, an IRA can be “converted” into a Roth. Doing so will incur full taxation on the amount converted but once done, the client will then reap the benefits of a Roth noted above.

This all brings me to the challenging question: “Which is more attractive, Brad and Angelina or 2010 and the Roth?”

The answer can be found buried deep inside 2006’s Tax Increase Prevention and Reconciliation Act, which states in tax year 2010, although income limits that allow or deny a contribution into a Roth do remain, converting an IRA into a Roth can be done by anyone. Prior to this year, if a client’s MAGI is greater than $100,000, a conversion would not be permitted. However, for this year and beyond, the $100,000 rule is completely lifted.

How good is that? ... It gets better.

In years prior and after this, when your client converts an IRA into a Roth, they will be required to include the entire amount converted (less nondeductible contributions) into their gross income for the tax year in which the conversion was made. This year, however, your client has the choice to report all or half the income from the conversion in 2011 and the remaining half in 2012.

Keep in mind, the same rules apply for Simplified Employee Pension Individual Retirement Account (SEP IRAs). As for Savings Incentive Match PLan for Employees (SIMPLEs), they be converted as long as the client has contributed a minimum of two years prior to the conversion taking place.

How to Convert

A conversion doesn’t require priests, rabbis or some sort of nuclear fusion process. “Doing” a conversion merely requires contacting the custodian holding the IRA and asking for a Roth conversion form. Custodians may call it different things, but all your client needs is a form that they sign and submit to convert their IRA into a Roth.

All or Nothing?

Some clients mistakenly believe converting an IRA into a Roth is an “all or nothing” deal, when in fact it’s not. With your assistance, a client might find that converting only a portion of their IRA into a Roth is the more effective road to pursue.

Should that be the case, all your client needs to do is transfer the portion of the IRA they wish to convert into a separate IRA and then convert this “new IRA” into a Roth. True, one can often save themselves the additional step in the process by simply transferring the portion of their IRA they want to convert directly into their current or new Roth (and avoid the extra step), but it’s best to keep clear records of what was done and this extra step can help resolve issues that may arise later. That said, this additional step becomes that much more important when factoring in the “best kept secret” about Roths.

The Best Kept Secret

One of the least known provisions of the Roth is also one of the most attractive.

Let’s suppose I own stock within my IRA and at some point this year I decide to convert the account (or a portion of it) into a Roth. Come April 2011, I’ll owe tax on the conversion. But looking at my statement, let’s suppose that no thanks to a bad market, my “new” Roth lost quite a bit of value since the conversion took place. If I was unaware of the best kept secret, I’d go ahead and pay taxes based on the higher stock price(s) when the conversion was done.

However, because I’m aware of this little known secret, as long as it’s done before October 15, 2011, I can actually “re-characterize” my Roth back into an IRA and then once again “re-convert” it back into a Roth, but this time, pay tax on the lower stock price(s).

Conclusion

Should everyone convert? No way. There are many reasons why your clients should or should not convert. Some that come to mind is how much time a client has until the IRA and/or Roth may or may not be used, from which the taxes will be paid and a number of other important factors not mentioned in this article due to space restraints. If you need assistance in running an analysis on key decision points, I have some simple and fantastic software at my fingertips that can help. Feel free to drop me an e-mail if you’d like and I’d be glad to lend a helping hand.

So, which is it? Brad and Angelina or 2010 and the Roth? By now you most likely know my answer, but the better question at this moment is, “what’s yours?”

Additional Resources: www.aicpa.org/PFP/Roth. The AICPA PFP Section provides information, tools, advocacy and guidance to CPAs who specialize in providing tax, retirement, estate, risk management and investment advice to individuals and their closely held entities. All members of the AICPA are eligible to join the PFP section. For CPAs who want to demonstrate their expertise in this subject matter apply to become a PFS Credential holder.

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Alan Haft is an investment advisor who makes frequent appearances in national print, television and radio media including The Wall Street Journal, Money magazine, CNBC, BusinessWeek and many others.

* For full disclosure, Haft is a part of a firm that utilizes all industries which typically includes us receiving percentage based fees for brokerage servicesas well ascommissions when implementing insurance based plans. I do not work for any particular financial company or industry nor should this column be construed as an endorsement or condemnation for any particular product. Readers should note that all views expressed in this article are solely the author’s and do not necessarily reflect the views of the AICPA CPA Insider™ or the AICPA.