Roth IRAs and Conversion Opportunities

1. Roth IRAs andConversion Opportunities Wayne D. Eski, CPA, CVA AEPC 1/28/08

2. Won’t cover • Roth 401k or Roth 403b • Complicated RMD rules • Inherited (stretch) IRAs • Investing in real estate via self-directed IRAs • Investments appropriate for IRAs

3. 10 yrs ago • Roth IRAs born under Taxpayer Relief Act of 1997. • Named after the late Senator William V. Roth Jr. • Special rule in 1998 allowed 4-yr spread to report the conversion income. • IRS Publication 590 and Form 8606. • Beginning in 2007 can file Form 8888 to request all or part of federal tax refund be paid directly into an IRA account.

4. Eligibility • Must have earned income. • Earnings limitation: Can not contribute to Roth IRA if Modified AGI in… 2007: >$114K if Single or >$166K if MFJ 2008: >$116K if Single or >$169K if MFJ • Maximum contribution: 2007: $4K + $1K catch up if age 50 2008: $5K + $1K catch up if age 50 (same as Traditional IRAs, but do not apply to Roth 401k/Roth 403b)

5. Ways to Fund(but not Roth 401k or Roth 403b) • Contribute after-tax dollars directly into account. • Convert existing traditional IRA (rollover distribution) • Starting in 2008, can directly convert a traditional 401(k) into a Roth IRA without having to roll it into a Rollover IRA first; Roth IRA eligibility requirements still apply and triggers conversion income.

6. Advantages of Roth IRA over Traditional IRA • Both have same annual maximum contributions. • Both allow tax-deferred compounding of earnings & growth. • Roth IRA contributions allowed regardless of age, whereas contributions to traditional IRA not permitted after age 70½. • Roth IRAs not subject to RMD rules during life - but beneficiaries are (different rules for spouse and nonspouse.) • Roth IRA contributions are made with after-tax dollars, thus Qualified distributions are tax-free (and not subject to withholding.)

8. What is a tax-free Qualified distribution? • 5-yr holding period, and • must be Age 59½, or • Death, disability or • Qualified special purpose under IRC 72(t) 3 most common: • Higher education costs • Medical > 7.5% AGI • $10K for first time home buyer (can be used for child/grandchild) If a Nonqualified distribution there are specific ordering rules, but basically if it all comes out the earnings are taxed at ordinary rates (and if <59½ subject to 10% penalty.)

9. Nonqualified distributions Specific Ordering rules: • Regular Roth contributions • Converted dollars (FIFO - deductible before non-deductible) • Earnings

10. Conversions • Conversions trigger income tax today in exchange for future tax savings. • Cost-benefit analysis should consider: • current and future tax rates (key) • time horizon • method of paying tax • expected rate of return • Nonspouses cannot convert inherited IRAs. • MAGI must be under $100K in 2008-09. • Beginning in 2010 no income limitation…

11. Conversions in 2010 and after • TIPRA eliminates the $100K conversion threshold. • Effectively everyone will be able to have a Roth IRA. • Income from 2010 conversions is reported in 2011/12. • If conversion in 2011 or beyond, taxes are due in the conversion year. • Money in the IRA converted should not be used to pay the taxes or penalties could be applicable. • Example…

12. Conversion Example 1 • Joe maxes out his 401(k) at work, but makes too much to contribute to a Roth IRA and was never persuaded to make nondeductible traditional IRA contributions. • His advisor convinces him to open a regular IRA and he funds the max in 2007-10 ($4+5+5+5=$19K basis) • In 2010 the account value (FMV) is $25K when he converts. • Tax result: Joe only pays tax on taxes on the $6K earnings. If Joe is in 25% bracket, he pays $1,500 in taxes: $750 in 2011 and 2012.

13. Conversion Example 2 (other IRAs exist) • Same facts as Example 1, but Joe has other IRAs including a SIMPLE IRA, SEP IRA, or rollover IRA resulting from a prior job. • The FMV of his other IRAs combined is $165K. • Joe’s tax basis in his other IRAs is zero. • Joe only wants to convert his Traditional IRA valued at $25K. • Basis calculation (pro-rata): $19K basis combined / $190K account value combined = 10%, thus, only 10% of the conversion is considered basis recovery. • Tax result: Joe must pay tax on $22,500 conversion income ($25,000 FMV less $2,500 basis). If he’s in 25% bracket he’ll pay $5,625 (spread over 2 yrs.)

14. Good conversion candidates • Someone with small or no IRA accounts. • Nonworking spouse of a retirement plan participant. • Someone who’s made nondeductible IRA contributions all along and has significant basis. • Someone who can roll their non-Roth, zero-basis IRAs into their employer’s qualified plan. • Nonspouses can NOT convert an inherited IRA.

15. Recharacterizations/Reconversions(Regular  Roth  Regular  Roth) ( convert / recharacterize / reconvert ) • Why recharacterize? • Post-conversion account value drops. • Ineligible to convert due to high income. • Can recharacterize up to October 15 of following year if return is on 6-month extension. • Not permitted to reconvert back to a Roth IRA before the later of Jan 1 of year after conversion or 30-days after the recharacterization. • Conversions done early in the year offer the flexibility to recharacterize and reconvert early in the next year.

16. Losses on investments held in Roth IRA • Current guidance treats same as rules for traditional IRAs and are deductible to the extent of unrecovered basis (regular and conversion contributions.) • Watch for unexpected tax trap: if withdrawal occurs within 5 yrs of conversion, a 10% penalty could apply on an otherwise tax-free distribution. • Example: in 1999 Jeff converted his sole zero-basis IRA worth $60K to a Roth IRA and invested in tech stock. In 2001 the Roth IRA is worth $25K and Jeff throws in the towel and withdraws the entire account at age 49. • Tax result: Jeff will be hit with $2,500 penalty tax on the withdrawal. He should also qualify for $35K misc itemized deduction subj to 2%.

17. Opportunities • If kids or grandkids have earned income from summer job, they can benefit from decades of compounding. • No RMD requirement makes Roth IRA a tax-efficient way to pass on assets to beneficiaries outside of probate. • taxes paid on conversion on behalf of future beneficiaries is not a taxable gift and reduces gross estate. • but Roth IRA is still included in gross estate for 706. • In most scenarios, a total or partial conversion will result in more wealth accumulation in the long run – especially if long time horizon and conversion tax is paid out of other assets. • Be certain of your client’s whole IRA picture and be aware of the tax consequences of a conversion when other IRAs exist.

18. Opportunities cont’d • Under current law, starting in 2010, high earners not eligible to contribute to Roth IRAs could make non-deductible contribs to a regular IRA and then convert to a Roth IRA the next day with no tax consequences. This could be repeated every year, circumventing Roth income limits on contributions. Don’t be surprised if Congress writes some anti-abuse provision into law before 2010. • Wacky as these rules may sound, a Roth IRA can be an effective way to achieve generally tax-free income in retirement and is a tool in your estate planning toolkit.

19. Q & A Thanks