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Jason Washo
Jason Washo
Accelerate Income

Pay tax sooner rather than later?

January 21, 2010
by Jason Washo, CPA, PFS

When you explain the concept of a Roth Conversion to a client some may think you have fallen off your rocker! It is very important to know your clients values and goals before making a purely mathematical recommendation to the client. There are excellent calculators and discussion materials available on Forefield (a benefit of PFS Section Membership) to help with the delivery of your recommendation. But it is important to remember the calculators can only go so far in explaining the benefits. In addition to the items we discuss here, I strongly recommend preparing a list of goals the conversion will accomplish for the client and their family. But who should consider a partial or total conversion?

Let’s first review clients who would likely be poor candidates for conversions.

Clients who would likely avoid converting include:

  • Their circumstances require they use funds from the Traditional IRA to pay income taxes and possible 10 percent premature distribution penalty
  • They need the money in the next five years
  • Their income tax bracket will be lower during retirement
  • Their State law does not provide bankruptcy protection for Roth IRA’s
  • No significant estate tax issue
  • Need to take the money at retirement
  • Will use all of the funds during retirement

Clients you should consider as candidates for conversion:

  • Can pay income taxes from other sources
  • Has a large net operating losses (NOL) they are carrying forward
  • Will not need money for next five years
  • Tax bracket will be higher in retirement
  • Your State law does provide bankruptcy protection for Roth IRAs
  • They have a large taxable estate
  • Client does not want to take RMD or doesn’t need the income
  • Looking for tax diversification
  • Would like to leave tax-free income to beneficiaries

Another significant advantage to making the conversion in 2010 is the ability for the client to pay taxes owed on the converted amount over the following two years. They could choose to include the distribution in the 2010 tax year. This is an either/or choice to include income in 2010 or spreading it over 2011 and 2012. If the client chooses the 2011 and 2012 method you will effectively achieve an interest free and tax free loan from Uncle Sam on the amounts they would have normally owed in 2010.

A Conversion Could Also Reduce Taxation of Social Security Income

Distributions from Traditional IRAs are added to provisional income for calculating the amount of Social Security Income that may be subject to income tax. Distributions from Roth IRAs are not included in provisional income, possibly resulting in an even greater tax savings to the client who converts.

What If the Converted Account Drops in  Value?

The provisions allow you to re-characterize or ‘un-do’ a conversion and put the money back into a Traditional IRA. Re-characterizing is allowed up to October 15th of the year following conversion. This is particularly attractive because it allows clients to convert assets in 2010, determine their values later in 2011 and determine with greater accuracy if converting was a good choice.

Converting a $100,000 account and paying taxes on the full amount where the account has dropped in value to a hypothetical $70,000 would be frustrating to say the least. Your client could simply undo the conversion and it would be as if the taxable conversion never happened. You also get as much as 22½ months to wait and see.

Some strategies recommend splitting Traditional IRAs based upon each asset class and then converting each account separately. I would only consider this for ultra-high-net-worth (UHNW) clients. It may not be feasible for smaller accounts. The advantage would be to re-characterize the accounts that performed poorly and keep the ones that performed well as Roth accounts. Then consolidate the accounts again post re-characterization deadlines.

Conversions completed as early as January 4, 2010 have up to October 17, 2011 to re-characterize before it is considered final by the IRS. This is one reason some people feel everyone should convert and analyze the decision later. I am much more conservative and believe you can consider the other factors previously mentioned before taking such an enthusiastic position.

What If the Client Has Non-Deductible Cost Basis in the IRA?

Cost basis in the IRA will help reduce taxes owed upon conversion, but the conversion rules specifically state all IRA’s must be aggregated for the purposes of calculating taxes owed upon conversion. So while this does prevent the client from converting only the assets with cost basis, it will help with the conversion taxes owed. While all IRA’s must be included, qualified plans such as 401(k)s are not included. Possibly creating a planning opportunity for those who have 401(k)s that accept rollovers.

Conclusion

Remember earnings in a Traditional IRA accumulate tax deferred and are treated as ordinary income upon withdrawal but will be subject to penalty if withdrawn prior to age 59½. Earnings in a Roth IRA accumulate tax deferred but can be withdrawn tax free provided the account owner is age 59½ and has owned the account for five years. Before implementing such a strategy, it is important that IRA account owners understand the tax ramifications, age and income restrictions with regards to executing a conversion from a Traditional IRA to a Roth IRA or a re-characterization of a Roth IRA to a Traditional IRA. And be certain to verify your own states treatment of Roth conversions. One state was known to us that passed legislation to make Roth conversions illegal (we will let the lawyers figure that one out!).

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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Jason Washo, CPA, PFS is an owner of Washo Financial located in Scottsdale Arizona. He has been the Financial Expert for AZ News Channel 3’s Web site MySweetConnection.com He has taught continuing education through the Arizona Society of CPAs and for the Arizona Council on Economic Education. He provides financial services to families and professionals in 12 states including AK, AZ, CA, GA, IL, IN, KS, MA, MN, NM, NV, OK. LPL does not provide tax or legal advice; seek advice from your tax or legal advisor for your situation. Washo offers securities and financial planning through LPL Financial. A Registered Investment Adviser. Member HUFINRAUH/HUSIPCUH.