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About converting to a Roth IRA

(2009-08-11 07:41:36) 下一个

About converting to a Roth IRA

Roth IRA conversions are about to become a big deal for people saving and investing for retirement. Under the Tax Increase Prevention and Reconciliation Act of 2005, or what some lovingly refer to as TIPRA, all taxpayers will be able to convert all or some of their traditional IRAs into a Roth IRA, regardless of income.

This is a game-changer, some are saying. So much so that firms and experts are fast at work training legions of advisers on the ins-and-outs of Roth IRA conversions. And soon these advisers will start pelting you with phone calls, emails and snail mail asking to schedule an appointment with you to talk about your IRA and the opportunity of a lifetime -- the chance to pay taxes now as a way to avoid paying more taxes later.

"The time to start clients planning is now as advisers look for practical and actionable strategies to address today's unprecedented market conditions," wrote Kevin O'Fee of Lincoln Financial Group in a recent article.

"TIPRA is reason to re-engage with those high-income clients by challenging the traditional rules of retirement, legacy planning and asset allocation. As such, advisers and clients alike will be well-served by evaluating the potential benefits of a Roth IRA conversion," O'Fee said.

We also think you'd be well served with answers to some of the most frequently asked questions about Roth IRA conversions -- before those advisers take O'Fee's advice and come a-callin.'

1. When do you report the income?

Prior to 2010, the amount converted would be reported as income on that year's tax return. Under TIPRA, however, conversions done in 2010 don't have to be reported on your 2010 tax return. Instead, you get to report the income on your 2011 and 2012 tax returns, said Barry C. Picker, a certified public accountant and financial planner with Picker, Weinberg & Auerbach, CPAs, and author of "Barry Picker's Guide to Retirement Distribution Planning."

Thus, if you converted a $100,000 IRA in 2010, you would report $50,000 in ordinary income in 2011 and $50,000 in 2012. In the parlance of advisers, you get to split the income.

If you do a Roth IRA conversion in 2011 or beyond, you don't get to spread the income or tax bill over two years. And that's why folks in the industry are salivating over this one-year-only bargain.

2. When do you pay the taxes?

If you split the income, you have to pay the taxes due on your 2011 and 2012 tax returns.

3. Do you have to split the income?

No. If you think splitting the income will create a larger overall tax bill, you can opt out of splitting the income over two years, Picker said.

4. If you elect out of the two-year split, is it all-or-nothing, or can you do it piecemeal?

According to Picker, it's an all-or-nothing election.

5. What happens if you convert to a Roth IRA when there is basis (the original amount invested) in the traditional IRA but it's worth less?

According to Picker, there is no official guidance on this question.

"There appear to be two possibilities, but in any event if the account is worth less than the basis there will be no income on the conversion," Picker said. "In one possible scenario, the taxpayer could take a miscellaneous itemized deduction for the loss in value, similar to the situation where the taxpayer had cashed out the entire account. In that scenario, the basis in the Roth IRA would be the value at the time of conversion," he said.

"The other possible scenario is that there would be no loss recognized on the conversion, but in that case the basis in the traditional IRA would carry over to be the basis in the Roth."

6. What about the five-year rule?

With a Roth IRA you get to withdraw your investment and earnings tax-free once you've met these requirements: You've owned the account for five years and you're 591/2, according to Ed Slott, editor of Ed Slott's IRA Advisor.

But when you do a Roth IRA conversion, there's a separate five-year clock that applies to "conversion basis amounts," said Ben Norquist, president and chief executive of Convergent Retirement Plan Solutions.

"If you are under age 591/2 at the time of a Roth IRA conversion, the amount you convert is subject to income taxes, but not the 10% early withdrawal penalty that typically applies to taxable distributions taken prior to age 591/2," he said. "The government doesn't want you to use the IRA conversion option as a work-around for avoiding the 10% early withdrawal penalty.

"So, to avoid this potential abuse, conversion basis removed from a Roth IRA within five years of conversion is potentially subject to a recuperative 10% penalty assuming you are still under age 591/2 at the time of Roth distribution," Norquist said.

Given the fact that there is a separate five-year clock rule that applies for determining whether a Roth IRA distribution is qualified or nonqualified, this conversion-specific five-year clock often causes confusion, Norquist said.

7. Can I convert my 401(k) to a Roth IRA?

Maybe. According to Slott's July newsletter, traditional IRA owners can do Roth conversions. That group includes individuals with SEP IRAs and SIMPLE IRAs, though you have to watch out for the early distribution penalty from a SIMPLE IRA.

But plan participants in 401(k)s, 403(b)s and 457 plans also can do Roth conversions as long as they are eligible to take a distribution from their plan and the funds are eligible for rollover to an IRA, he wrote. Slott's recommendation: Check whether your plan will allow in-service distributions so that those funds can be converted now instead of waiting until you stop working.

8. Can I do a partial conversion?

Yes. In fact, the fun part is trying to figure how much of your traditional IRA you should convert, Slott wrote.

9. What if I have a non-deductible traditional IRA?

Let the fun begin. Here you have to consider the total value of all your IRAs when converting all or a portion and use the pro-rate rule, according to Slott. So, if by chance you have $500,000 in four IRAs, one of which has $50,000 in after-tax contributions, then Uncle Sam will only tax you on 90% of the amount converted. You can't only convert the non-deductible IRA.

10. Paying the piper

Some folks say it's OK to use money from your IRA to pay the tax bill due. Others, including Slott, say no. The reason being: If you decide to undo the Roth IRA conversion (recharacterize it), "the funds taken from the IRA to pay the taxes can't go back in as part of the recharacterization," Slott wrote.

11. Can you convert to multiple new Roth IRAs rather than just one?

The short answer is yes.

Consider converting to separate new Roth IRAs that don't contain any other Roth IRA funds from prior years, Slott said. What's more, don't convert to just one Roth IRA. Instead, Slott recommends converting to a number of Roth IRAs that each hold one type of investment. That way it's easy to undo the conversion if the investment doesn't pan out. "You can cherry-pick the losing Roth IRA, to get a lower tax cost via recharacterization, while leaving the winners to keep growing and eventually pay out tax-free profits," Slott wrote.

12. Convert some in 2009?

It's a good question. If you think your tax bracket would be lower in 2009 and the value of your investments will be lower in 2008 than at the end of 2009, it might make sense to convert some of your IRA this year.

As always, consider this and the other tactics with the help of a qualified professional.

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