Financial planning often requires us to face our own certain demise – something that we often don’t want to do, but still a certainty that we all must face.

Among the things that we want to do when planning for the inevitable would be to make certain that our surviving loved ones have access to adequate monetary resources to support themselves, in the most cost-effective manner.  Another thing that we hope to accomplish is to make the transition as easy as possible for our loved ones.  One way to do this is to convert a good portion of your IRA or other tax-deferred funds to a Roth IRA account.  Here’s why:

By converting to a Roth account, you will make the funds in that account available to your heirs totally tax free.

Granted, your estate will also be smaller by the amount of tax that you paid on the conversion.  At the same time, your heirs will also not have to go through the rather painstaking process of managing the IRD deduction, if the estate is of a size that requires estate tax to be paid.  This will simplify the overall process dramatically, and depending upon the size of your overall estate this could be a significant.

On the downside of this, it’s likely that if you convert your account in a single year the tax paid on the conversion would be much, much higher than if your heirs paid tax on the ordinary required distributions if the account is left as a traditional IRA.

However, if you converted your account over several years in smaller amounts using a strategy like filling up the brackets, the overall tax cost of the conversion will be less, maybe even less than the cost that your heirs would experience otherwise.

You can always use recharacterization strategies to make sure that the whole process is as tax-efficient as possible. And in today’s tax climate (and market volatility) there are literally very few reasons not to go ahead with a Roth conversion strategy.

You can pick up my book, A Social Security Owner's Manual, at Amazon in either the print version or the Kindle version by clicking the links.
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If you’re in a relatively low tax bracket and have funds in a traditional IRA or Qualified Retirement Plan, chances are you might be in a position to set yourself up with tax-free income via a Roth Conversion.  One method that can work in your favor is the “fill up the bracket” technique, and if you want to do this for 2011, you’re running out of time, it must be done by December 30 (December 31 is a Saturday).

The way this works is that you determine what your regular income is, and then look at where you are with regard to your tax bracket.  If there’s still some “headroom” in the current bracket, you could convert an amount, equal to or less than your “headroom”, from your traditional IRA to a Roth IRA.  This way you are controlling the tax rate at which your conversion occurs, keeping it in the lower tax bracket.  By doing this, you are reducing the value of your traditional IRA and therefore the size of your future Required Minimum Distributions (RMDs) while increasing the amount you have in Roth IRA accounts for future tax-free growth.

Well that was clear as mud, right?  Let’s work through an example.

Fill Up the Brackets Example

Let’s say your taxable income (before any conversion) is $50,000.  This puts you in the 15% tax bracket, and (for 2011) this leaves $19,000 of headroom in the bracket, up to $69,000 in taxable income for a married couple filing jointly.  Given these facts, you could convert as much as $19,000 from your traditional IRA, assuring that you’d only pay 15% on the additional income – assuming that the increase in ordinary income doesn’t have an adverse impact on your deductions and/or credits.

If you did this over the course of several years, it could significantly reduce the balance in your traditional IRA, thereby reducing the amount of your future Required Minimum Distributions (RMDs) from the traditional IRA(s).  Then you’d have significant money set aside in the Roth account which could grow tax-free for the rest of your life.

Additional Concerns

Of course, as with all Roth conversions you need to project into the future what your tax rate will likely be in order to make sure this is a proper move.  If your projected future tax rate will be equal to or more than the bracket you’re in today, then the Roth Conversion makes sense.  This requires you to make assumptions about the future tax rates, and so if you’re pessimistic (realistic?) you’ll assume that the rates in the future will increase.

Generally, unless you expect your income to decrease in the near future, it might work best to convert at least small amounts now, paying the tax when you have the ability.  This will provide you the option of controlling (at least somewhat) your tax burden in the future.  Every person’s situation is going to be different, and as such there is no rule of thumb to determine if the conversion makes sense for you.

One way that this could work in your favor is if you’ve been let go from your job early in the year, thereby reducing your overall income for this tax year.  If this happens you might be in a much lower tax bracket than you normally would be, providing you with lower tax bracket headroom in order to employ this tactic.

One other thing you need to keep in mind with this tactic (and all IRA distribution tactics, including all Roth Conversions) is the tax impact to your Social Security benefits (if you’re receiving them currently).  If your nominal income is low enough to allow for less than the full 85% taxation of your Social Security benefits, recognizing additional income via a Roth Conversion could bump you up over the limit.  This would cause additional income from the Social Security benefit to be taxed, increasing your tax hit on the conversion as well.

You can pick up my book, A Social Security Owner's Manual, at Amazon in either the print version or the Kindle version by clicking the links.
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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

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For those of you who took advantage of the one-time opportunity in 2010 to convert IRA funds to Roth IRA accounts, spreading the tax over the following two years (2011 and 2012), you are faced with a decision-point:  if you have reason to recharacterize the conversion, you have to do this by October 18, 2011.

Why might you want to recharacterize?

Here’s a ferinstance: If you converted $10,000 from your IRA account on December 31, 2010 into your Roth IRA and invested it in the S&P 500, that $10,000 converted is now worth approximately $8,997 (using a recent price).

If you are in the 25% bracket, you will owe $2,500 on the conversion, which equates to 27.79% in taxes on the conversion.  If your chosen investments did worse than the S&P 500 (and you know some of them probably did), your effective tax will be even higher.

Now, chances are that your investment may increase in value before you actually pay the tax on your 2011 and 2012 returns, but then again maybe it won’t.  Why pay the extra tax (or rather, the tax on the extra amount) if you don’t have to?

You can recharacterize the amount in your Roth IRA that corresponds to this conversion back into your traditional IRA – but you must do it before October 18.  At that time, you’ll also want to file an amended tax return showing that the conversion “did not happen” for tax year 2010.

On the other hand

If you bought the S&P 500 about a year ago with that same $10,000, it’s likely worth about $10,335 today, so you might want to leave the conversion alone.  Now your effective tax rate on the conversion (if you’re in the 25% bracket) is only about 24.19%.  Granted, it’s not a dramatic increase, but still it probably is better than you originally thought when you started this process.  And you’ve got two more years to pay all of the tax.

You can pick up my book, A Social Security Owner's Manual, at Amazon in either the print version or the Kindle version by clicking the links.
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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

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If you find yourself in the position of having too high of an income to make a deductible contribution to your IRA for the year ($110,000 for joint filers in 2011, $66,000 for Single and Head of Household), you may be wondering if it’s a good idea to make a non-deductible contribution to your IRA.

There are two opposing camps on this issue, and the deciding factor is how you’re intending to use the funds in the near term.

It’s a Good Idea

If you’re intending to convert your IRA to a Roth and your income is too high to just make the contribution directly to the Roth account, the non-deductible IRA may be the right choice for you.  This way you’re effectively working around the income limitations of the Roth contribution ($179,000 for joint filers in 2011 or $122,000 for single or head of household filers).

You also have more funds available in your IRA account, which provides you with the ability to take advantage of economies of scale – certain mutual funds have higher minimum purchase amounts, for example.  Since the money is in an IRA you don’t have to track holding periods, non-qualified dividends versus qualified dividends, and your paperwork is reduced.

In addition, depending upon your state laws your money may be protected against creditors since it’s part of an IRA.

No, It’s a Bad Idea

If you’re not planning to convert this IRA to Roth, you’re effectively increasing the tax cost of your investment gains (under today’s law).  Since withdrawals of investment gains from your IRA are taxed at ordinary income tax rates (up to 35% under today’s rates), you’re effectively giving yourself a tax increase over the capital gains rate which is 15% at the maximum these days.

Instead of making a non-deductible contribution to your IRA, you could just make your investment in a taxable account.  Then within this account you could make investments geared toward long-term gains rather than income or dividends, therefore deferring tax until you sell the investment.  And when you do sell the investment it will be taxed at the currently much lower capital gains rate versus the ordinary income tax rate (which would be applied if you made your contribution in the IRA).

Conclusion

So – depending on what you’re planning to do with the account, a non-deductible contribution could be a good idea or a bad idea.  You will have to make that call.  Hopefully the information above will help you with your decision.

You can pick up my book, A Social Security Owner's Manual, at Amazon in either the print version or the Kindle version by clicking the links.
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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

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The rule is that you are restricted to one IRA rollover in a 12-month period.  So let’s define a few things for the purpose of this discussion:

Rollover – this is when you move money from one IRA to another, first taking possession of the funds prior to depositing the funds into the new (or the same old) account.  You have 60 days to complete this process.  At the end of the tax year you’ll receive a 1099R from the original custodian, with a distribution code of 1 or 7 (this form is important to the rule).

Transfer – Also known as a trustee-to-trustee transfer or a direct rollover, in this case you do not take possession of the funds, they are transferred directly from one IRA to another.  Another possible way this could occur if you receive a check from the old custodian made out to the new custodian.  Typically this sort of movement of funds does not generate a 1099R at the end of the year, as you’ve not actually made a distribution – no taxable event has occurred.

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12 months – this really means a full year, 365 days in a normal year, 366 days in a leap year.

The Rule

Now that we have our definitions, here is the rule:

You are restricted to only one Rollover for each IRA account, either receiving or distributing during a full 12 months from the date of distribution.

Transfers are not influenced by this rule. You are allowed to make as many transfers between IRAs as you like, uninhibited by the rule.

An example is in order:  You have an IRA at Mutual Fund Company A, and you take a rollover distribution, and you deposit the money into your IRA account at Brokerage B.  You are restricted in that you cannot make any other rollovers into or out of these two IRAs.

If you have other IRAs, the rule does not apply to those – only IRAs that have been subject to rollover (as defined above) into or out of them within the previous 12 months.

Roth IRA Conversions and Recharacterizations do not apply to this rule either – these are different sorts of distributions, and can be taxable events, but are not subject to this rule’s restriction.

Lastly, the rule does not apply to rollovers into or out of Qualified Retirement Plans (QRPs) such as a 401(k).  You are free to do as many rollovers into or out of an IRA to/from QRPs with no time restrictions.

Hopefully this has helped to fully clarify the rule.

You can pick up my book, A Social Security Owner's Manual, at Amazon in either the print version or the Kindle version by clicking the links.
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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

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Social Security taxation: Especially if you had unusual income taxed in 2010, such as a Roth Conversion, you could be subject to as much as 85% taxation of your Social Security benefit.

Alternative Minimum Tax: If you’ve been impacted by this, not only are your ordinary income tax items taxed at a higher rate, but your capital gains and dividends could be taxed at a rate higher than 15% as well.  This happens for folks with incomes between $150,000 and $439,800 (or $112,500 and $302,300 for singles) as the AMT exemption phaseout occurs.

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Child Tax Credit: If your income is over $110,000 ($75,000 if filing Single), the Child Tax Credit reduces by $50 for each $1,000 over that limit.  This has the effect of increasing the marginal tax rate by 5% for each child, as your income increases.

Passive Loss phaseout for rental realty: If your AGI is greater than $100,000, the deduction of up to $25,000 of losses from rental real estate is phased out up to an AGI of $150,000 when the deduction is eliminated altogether.  This can increase the marginal tax rate by 50% ($25,000 credit eliminated as your income increases by $50,000).

There may be other reasons that impact your tax bill, but these are some that have recently come to light as typically occurring.

You can pick up my book, A Social Security Owner's Manual, at Amazon in either the print version or the Kindle version by clicking the links.
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When you have the bulk of your financial assets in retirement plans, you might accidentally expose yourself to some risks that you haven’t thought about… since retirement plan assets are much more likely to be impacted by changes to legislation – as we have seen in the past.

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In these days when Congress is looking for money just about everywhere, it’s not a stretch to imagine new legislation coming down the pike to tax retirement plan assets (like the 15% “excess” plan accumulations that was enacted in 1986 and later repealed).  Other possibilities include accelerating required minimum distributions to achieve a faster payout taxation of the plan; eliminate the “stretch” provisions; or even nationalization (yikes!) as suggested to Congress by experts as recently as 2008.

Assets held outside of retirement plans enjoy capital gains tax treatment (under current law) that is generally much more favorable than the ordinary income tax rate. Plus, these assets also can receive a step-up in basis when passed to your heirs, removing the capital gains on a lifetime’s appreciation in the account, whereas retirement plan assets do not receive this treatment.

This is not to say that you want to eliminate your retirement plans altogether, but rather to balance your assets by tax treatment.  It makes good sense to diversify by tax treatment, as a hedge against the various things that could occur to the retirement accounts.

There is no perfect formula for determining what is the appropriate amount to maintain in tax-deferred retirement plan accounts versus taxable versus Roth accounts – this is determined by the individual, along with his or her trusted advisors.

Sometimes it makes sense for the individual to have the lion’s share of his or her savings in deferred accounts, such as when we’re very young.  At other stages in life (early retirement before age 70½, for example) it could make a lot of sense to start eliminating the deferred accounts in favor of Roth or taxable accounts.

The idea is to weigh the tax impacts of moving money about against the potentialities that are out there for massive changes to the tax treatment rules on those accounts.

You can pick up my book, A Social Security Owner's Manual, at Amazon in either the print version or the Kindle version by clicking the links.
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Prior to 2006, this could really cause a problem, especially if you don’t need the funds at the time.  In a good situation the plan might require a 5-year payout; for a rough go of it, they might push you to take the entire amount in a lump sum.  Since PPA in 2006, there has been a direct rollover option available to beneficiaries of QRPs.  You can set up an inherited IRA account (using the name of the decedent in the title, such as “John Jones, deceased, FBO Jane Jones”) and then perform a direct, trustee-to-trustee rollover into the IRA from the QRP.

This will satisfy the plan’s requirement for the lump-sum payout, while at the same time giving you the option of stretchout of the distributions over your lifetime.  It is important to note that this rollover must be a direct, trustee-to-trustee rollover – the 60-day rollover cannot be used in this case!

Roth it!

One additional way to deal with such a payout requirement is to convert the QRP directly to an inherited Roth IRA account.  Again, you need to ensure that the account is titled appropriately as mentioned above.  But then you can convert the QRP to the Roth account.

This may be another good reason for leaving your retirement account in a 401(k) plan – since there is still no way that an inherited IRA may be converted to a Roth IRA account.  In this case the heir has the flexibility to convert the funds rather than rolling them over.

A downside to this is that the inherited Roth IRA is required to distribute its funds to the heir over the heir’s lifetime – which is different from your normal Roth IRA.  A standard, owned Roth IRA account does not have to distribute the account’s funds during the lifetime of the owner, but any inherited Roth IRA does.  This is true whether the original account that was inherited was already a Roth IRA, or if it was converted from a QRP into the Roth.

You can pick up my book, A Social Security Owner's Manual, at Amazon in either the print version or the Kindle version by clicking the links.
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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

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Recharacterization is the “backing out” of your Roth conversion.  In other words, you can literally make the conversion as if it had never been done at all, with your money back in the traditional IRA where it started.

Why would you want to do that?  Here’s an example: let’s say you converted $100,000 to a Roth IRA in 2010 and you are ready to pay the tax on your 2010 return (you elected out of the spread to 2011 and 2012).  Except that now, your investment in the Roth IRA has dropped in value to only $50,000 – and you still owe tax on the conversion of $100,000!  Yikes – that’s just totally wrong!

Recharacterization can help to save you in this situation.  As long as you act before the due date of your return (including extensions), you can put recharacterization to work for you, moving the $50,000 back to the traditional IRA.  It will be as if nothing was done at all, and no taxes are owed.

Actually, as far as the IRS is concerned you are not moving $50,000 back, you’re moving the original $100,000 and the gains or losses on that original $100,000, which happens to equal $50,000.

Recharacterization Strategy

One way to use this to your advantage is to split your Roth conversions up into separate accounts by specific types of assets, so that if one of the asset types (or more) happens to drop significantly in value, you can recharacterize the conversion on only that account, leaving the other account(s) intact.

This would help with your record-keeping, since any amount that you recharacterize from a Roth to a traditional IRA must include the gains or losses that are attributable to the recharacterized amount.  Of course, you wouldn’t likely recharacterize unless you had net losses in the Roth account – although you might find that recharacterization is a good option if you came up short of cash to pay the tax on the original conversion.

Photo by Wikimedia

You can pick up my book, A Social Security Owner's Manual, at Amazon in either the print version or the Kindle version by clicking the links.
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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

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But what about if you converted funds from two or more IRAs to Roth during 2010… can you have part of the funds taxed in 2010 and part of it taxed during 2011 and 2012?

Unfortunately, you can’t do this.  This goes back to the one very important factor that applies to Roth conversions:  the IRS considers all of your IRAs as one single, aggregated account for purposes of distribution taxability.  Therefore, no matter how many accounts you may have converted from in 2010, all of the distributions must be treated the same way.

Two things allow for some flexibility on this matter though…

1. If you had other distributions in 2010 (besides your conversion), these will certainly be taxed on your 2010 return, and you still can elect to have your conversion funds taxed in 2011 and 2012 if you’d like.
2. If you are married, each of you can choose a different taxation method for your Roth conversion funds, effectively spreading your household taxation over all three years if you like.  Your husband could have his converted funds taxed in 2010 and you could spread the tax on your converted funds over 2011 and 2012, for example.

Photo by dave_7

You can pick up my book, A Social Security Owner's Manual, at Amazon in either the print version or the Kindle version by clicking the links.
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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

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