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Should You Do A Roth IRA Conversion?

The federal government may have given you the opportunity to save tens or even hundreds of thousands of tax dollars — if you’re willing to deal with some complexity. Will you take advantage of it?

Beginning this year, all taxpayers will be allowed to convert their traditional IRAs to Roth IRAs, regardless of their income levels. With tax rates already scheduled to increase in 2011 and the possibility of additional tax hikes on the horizon, now is the time to decide whether a conversion is right for you.

Unlike traditional IRAs, where contributions are typically made with before-tax dollars and distributions are treated as taxable income, Roth IRA contributions are made with after-tax dollars. Distributions from Roth IRAs are typically tax-free. In addition, taxpayers are not forced to take required minimum distributions (RMDs) from Roth IRAs. This allows retirement assets to compound even longer, tax-free. The conventional wisdom is that unless you expect your tax rate to be lower in the future, a Roth IRA is preferable since it allows you to grow your assets tax-free.

But in the past, Roth IRAs weren’t available to high-net-worth individuals. Wealthy taxpayers who wished to shelter their retirement savings from income taxes were limited to tax-deferred accounts such as traditional IRAs, 401(k)s, and profit-sharing plans. Unfortunately, as tax-deferred assets grow, so does the income tax embedded in those assets. But now, for the first time, large amounts of tax-deferred assets can be converted into Roth IRAs and become tax-free assets.

To Convert Or Not To Convert?

There are several variables to consider in determining whether a conversion is in your best interest. Some, such as your age, your expected investment rate of return and how long you expect to live, may affect the amount of potential savings (or losses) from a conversion, but should not play major roles in your decision. The two main variables are whether you have funds outside of your retirement accounts that you can use to pay the taxes associated with a conversion, and your expectations for your current and future tax rates.

If the only funds you have to pay the income tax associated with a conversion are traditional IRA assets, converting is likely to be unattractive. The new Roth IRA would have a significantly lower beginning balance (because of taxes paid) with which to grow in the future. By paying the tax with assets held outside of a traditional IRA (such as funds in a bank account or a taxable brokerage account), you’re effectively swapping tax-inefficient assets for tax-efficient assets. For example, funds in a bank account or taxable brokerage account are likely to generate dividends, interest income and capital gains, all of which increase your tax bill. In a Roth IRA, this income is exempt from taxes. By making the swap, over the long term your tax bill is likely to drop and the size of your portfolio increase.

Assuming you have funds outside of your traditional IRA to pay the tax, the other important variable to consider is your tax rate. If you believe that it will be higher in the future, a conversion is probably in your best interest. Any traditional IRA assets that you convert in 2010 will be treated as ordinary income on your tax returns. If you can pay the tax now at a lower rate than you would in the future, that’s a winning proposition. If you expect your tax rate to be lower in the future, you’re better off leaving your traditional IRA alone, rather than triggering any taxes now. Tax rates are scheduled to increase in 2011, with the top federal rate rising from 35 percent to 39.6 percent. Several states have already raised their tax rates, and it is very possible that additional state tax hikes may be coming. With federal and state governments running deficits and looking to fund various initiatives, it is difficult to envision a scenario in which tax rates would go anywhere but up for high-net-worth individuals.

Even if you expect your tax rate to be the same in the future as it is now, converting is likely to be in your best interest. This is because, as described above, by swapping out your tax-inefficient assets for tax-efficient assets, you can reduce the government’s cut of your investment gains going forward.

Still on the fence? There are also tax benefits for your heirs if you do a Roth conversion. When a taxpayer dies, his or her traditional IRA is subject to both income tax and estate tax. Although a Roth IRA is still subject to estate tax, the heirs can receive the Roth IRA assets free of income tax.

Assuming that you have non-IRA funds to pay the tax associated with a conversion and that you don’t expect your tax rate to decrease, a conversion is likely to be in your best interest. Converting your IRA is a relatively straightforward procedure; all it should require is a simple form from your financial institution.

Following Up: Recharacterizations

After you submit the paperwork and your IRA has been converted, you may feel a sense of relief. You’re going to save a bunch of money on your taxes! However, converting your IRA is actually only the beginning of the process, not the end.

The reason the process doesn’t end after your IRA has been converted is that conversions are revocable. The reversal of an IRA conversion is called an IRA recharacterization, and it can save you a lot of money. A recharacterization results in the assets being transferred back to your traditional IRA, effectively undoing the conversion. There are two instances where recharacterizing would be in your best interest: if the value of your converted assets declines, or if a conversion pushes you into a higher tax bracket.

First, assuming that your retirement assets decline substantially in 2010 after conversion, you do yourself a great disservice by not recharacterizing. After all, why pay tax on the dollar amount originally converted in 2010, when, if you recharacterize and then re-convert a lower account balance in 2011, you can pay a lower tax? This would be preferable to paying taxes on the funds that were lost due to market declines.

Second, if a conversion of your entire IRA pushes you into a higher tax bracket, it may make sense to recharacterize a portion of the converted assets. Assuming this is the case, you can instruct or work closely with your tax preparer to ensure that you take advantage of recharacterizing to avoid being subject to a higher tax bracket.

The exercise of recharacterizing your IRA because of market declines or to avoid higher tax rates may continue for several years, to ensure that you pay the lowest possible amount in taxes. You have until the extended deadline for your income tax returns (as late as October 15) to recharacterize your converted IRA assets for the previous year.

Another planning opportunity that presents itself with your IRA is the option to “cherry-pick” which IRA investments to convert, and which to recharacterize. You may open multiple Roth IRAs and transfer different investments from your traditional IRA to each of the new accounts. For example, one may hold U.S. equities, another may hold international equities and so on. At the end of 2010, you can leave the Roth IRAs that appreciated in value alone, while recharacterizing all IRAs that declined in value and re-converting them in 2011.

After The Conversion

After you have converted your IRA assets, there are still a few things to keep in mind. Since you won’t be required to receive RMDs from your Roth IRA, we would not recommend taking withdrawals from it until your other assets have been depleted. If you deplete your other assets and have no choice but to take withdrawals from your Roth IRA, make sure that you avoid early distribution penalties. If you are under 59½ and take withdrawals within five years of an IRA conversion, the distributions may be subject to a 10 percent early distribution penalty.

Assuming you have sufficient non-IRA assets, it is possible that you may never have to take a distribution from your Roth IRA. In an ideal scenario, you would spend down your other assets, and the Roth IRA would pass to your designated beneficiaries as part of your estate plan.

As you can see, this is a complicated decision that may take several years to implement effectively. If you’re interested in converting your traditional IRA, we recommend starting the process as soon as possible. By converting now, you can shift any future appreciation into the Roth IRA, where it will never be taxed. And you retain the ability to reverse the conversion using an IRA recharacterization.

It’s not often that Uncle Sam gives wealthy taxpayers a break. While this opportunity is not scheduled to expire, tax laws can and do change. Don’t let the opportunity to reduce your tax bill and increase the size of your portfolio pass you by.

Editor’s Note: If you have questions that were not addressed in this article, or if you would like to discuss this decision with a financial planner at Palisades Hudson Financial Group, please feel free to contact us at 1-877-485-4000, or by email to info@palisadeshudson.com.

Managing Vice President Paul Jacobs, of our Atlanta office, is among the authors of our firm’s recently updated book, The High Achiever’s Guide To Wealth. He wrote Chapter 20, "Giving Back." Paul also contributed to the firm’s book previous book, Looking Ahead: Life, Family, Wealth and Business After 55.
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