Tennessee Estate Planning Law : Tennessee Estate Planning Lawyer & Attorney : Bryan Howard : Howard & Mobley Law Firm : Nashville, Chattanooga, Memphis

This is the eighth and final article of a series dealing with the topic of converting your traditional IRA to a Roth IRA. For prior articles, see:

Part 1 – Reasons to Consider the Roth Conversion
Part 2 – The Recharacterization Option
Part 3 – The Impact of Income Tax Rates
Part 4 – How Long Can You Stretch?
Part 5 – The Impact of Investment Returns During the First 21 Months
Part 6 – The Impact of Estate Taxes
Part 7 – Ramifications of Charitable Giving

Roth IRAs  are tremendous assets to own because they grow tax-free, allow tax-free withdrawals, and do not require you or your spouse to make withdrawals.

Determining whether the cost of a Roth IRA is a good investment depends on numerous factors, including income tax rates that will apply to you and your family now and in the future, whether you and your family can pay the conversion tax and meet your spending needs from other sources, whether you will be subject to estate taxes, and how much you plan to give to charity during your lifetime and at death.

Wealthy families are the most likely candidates to benefit from a Roth IRA conversion because they are likely to be in a high income tax bracket in the future, they can pay the conversion tax and meet spending needs from other sources, they will be subject to estate taxes, and they are able to make additional charitable gifts to offset the income tax generated by the conversion. 
 

The recharacterization option is a valuable tool which allows you to make a conversion and then change your mind as long as 21 months later. During this 21-month period, you will see tax law changes that have occurred and how your investments have performed. When you make a conversion, you should create several Roth IRA accounts, with each account holding different asset classes, in order to maximize the flexibility afforded by the recharacterization option.
 

Most wealthy individuals should make a conversion and follow the steps outlined in the following timeline.
 

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This is the seventh article in a series of eight articles dealing with the topic of converting your traditional IRA to a Roth IRA. For other articles, see:

Part 1 – Reasons to Consider the Roth Conversion
Part 2 – The Recharacterization Option
Part 3 – The Impact of Income Tax Rates
Part 4 – How Long Can You Stretch?
Part 5 – The Impact of Investment Returns During the First 21 Months
Part 6 – The Impact of Estate Taxes
Part 8 - Putting It All Together

Individuals who make significant charitable gifts have additional considerations when evaluating whether to convert a traditional IRA to a Roth IRA. A lot of my clients plan to give at least a portion of their traditional IRA to charity upon their death. In addition to wanting to make charitable gifts, these clients realize that the bequest to charity will avoid income taxes and estate taxes. Individual beneficiaries would have to pay income taxes if they received the IRA. Furthermore, if the IRA owner’s estate is larger than the allowable estate tax exemptions, there will also be estate taxes imposed upon the portion of the IRA that is paid to children.

Individuals who plan to give their IRA to charity have less to gain by making a conversion. If you are planning to leave a portion of your IRA to charity, a conversion will cause you to pay income taxes now that you might not otherwise be paying later. In certain circumstances, you can still justify making the Roth IRA conversion. Nevertheless, I have discouraged my clients who plan to leave their entire IRA to charity from making the Roth conversion.

Some IRA owners intend to leave only a portion of their IRA to charity. Assume that Mrs. Brown has a $500,000 IRA and the beneficiaries are designated as follows: $100,000 to XYZ Church, $100,000 to XYZ University, and the balance to children.

Mrs. Brown can convert a portion of the IRA to a Roth IRA. Ideally, she will not convert beyond the amount which will allow there to be at least $200,000 in her traditional IRA upon her death. Some guesswork will be required to determine how much to leave in the traditional IRA so that there is at least $200,000 at the time of her death because there will be earnings and required minimum distributions during her remaining lifetime.

Assume that Mrs. Brown expects to live to age 90 and her investment advisors recommend that she leave at least $300,000 in her traditional IRA so that there will be at least $200,000 left when she dies. She should convert the entire $500,000 and place $100,000 in five separate accounts. No later than October 15 of the year following the conversion, she will recharacterize three of the accounts, or perhaps more if investments have performed poorly. This technique allows her to make the conversion with the best performing accounts while leaving sufficient funds in the traditional IRA to make the charitable bequests at the time of her death.

Your lifetime charitable giving is also relevant to the Roth conversion analysis. You will recognize income in the year of the conversion. For conversions in the year 2010, you can elect to recognize 50% of the income in the year 2011 and 50% in the year 2012. If you know that you will be making large charitable gifts in the future, you may choose to accelerate those gifts into the year of the conversion (or into 2011 and 2012 for conversions in the year 2010).

If you need a charitable deduction now, but do not want the charities to receive the funds until later, your charitable donation can be “escrowed” in a donor advised fund or a private foundation. Both of these structures allow you to identify the charitable recipients and make the actual charitable gifts in a later year.

In summary, you should consider accelerating charitable gifts to reduce income taxes attributable to a conversion of your traditional IRA to a Roth IRA. You should not convert the portion of your traditional IRA that you intend to leave to charity upon your death.
 

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This is the second article in a multi-part series dealing with the topic of converting a traditional IRA to a Roth IRA. For other articles, see:

Part 1 – Reasons to Consider the Roth Conversion
Part 3 – The Impact of Income Tax Rates
Part 4 – How Long Can You Stretch?
Part 5 – The Impact of Investment Returns During the First 21 Months
Part 6 – The Impact of Estate Taxes
Part 7 – Ramifications of Charitable Giving
Part 8 - Putting It All Together

This article will focus on recharacterizations. A recharacterization allows you to change your mind and undue a Roth conversion. This is such a valuable option, that it will significantly influence how many people choose to make a conversion.

A recharacterization can be made any time before October 16 of the calendar year following the conversion. This means that if you make the Roth conversion in January of 2010, you can recharacterize as late as October 15, 2011. You have nothing to lose by making the conversion in 2010. You can make the conversion, evaluate the consequences for up to 21 months, and then recharacterize if you decide that the conversion was a bad idea.

A decline in the value of the Roth IRA after the conversion will be a common reason for making a recharacterization. Alternatively, you might decide that you cannot afford to pay the tax from separate assets or that you or your children will be in a lower tax bracket in the future.

If you recharacterize, you must recharacterize the entire Roth IRA account. However, you do not have to recharacterize all Roth IRA accounts. If you segregate your IRA into multiple Roth IRAs at the time of the conversion, you will be able to pick and choose which accounts you recharacterize. If one or more of the accounts goes down in value, you may be well advised to recharacterize the accounts that have declined in value. You should work with your investment advisors to fund the various accounts with different assets whose historical returns have not been highly correlated.

If you only plan to convert a portion of your IRA, you might as well convert the entire account and create several Roth IRAs. You can then recharacterize the accounts that have the lowest investment return.

After you recharacterize, you can reconvert to a Roth IRA again. The reconversion can be made on the later of (a) 30 days after the recharacterization; or (b) the taxable year following the taxable year of the original conversion. For example, if you convert in January of 2010 and recharacterize on November 1, 2010, you will have to wait until January 1, 2011 before you can reconvert. If you recharacterize a January 2010 conversion on October 15, 2011, you will be able to reconvert on November 15, 2011.

Because the deadline for recharacterizing is October 15 of the year following the year of the conversion, there is an advantage to making a conversion in the early portion of the year. If you convert in December, you will have 10 months to decide whether or not to recharacterize. If you convert in January, you will have as much as 21 months to evaluate the decision.

In summary, the ability to recharacterize a Roth IRA conversion will cause numerous individuals to “test the waters” even if they are not convinced that the conversion is a good idea for them. When you convert your traditional IRA to a Roth IRA, you should consider splitting the IRA into several Roth IRAs so that you can maximize the benefits afforded by the recharacterization option.

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This is the first article in an eight part series on Roth IRA conversions. For other articles, please see:

Part 2 – The Recharacterization Option
Part 3 – The Impact of Income Tax Rates
Part 4 – How Long Can You Stretch?
Part 5 – The Impact of Investment Returns During the First 21 Months
Part 6 – The Impact of Estate Taxes
Part 7 – Ramifications of Charitable Giving
Part 8 - Putting It All Together

A lot of my clients are planning to take advantage of a new opportunity that will be available for the first time in January of 2010. They will be able to convert their traditional IRA account to a Roth IRA account. The conversion opportunity has been available for several years, but only to individuals with less than $100,000 of adjusted gross income.

Roth IRAs offer several benefits. Like Traditional IRAs, Roth IRAs do not have to pay taxes on their earnings. However, unlike traditional IRAs, qualified distributions from Roth IRAs are not subject to income taxes.

Another advantage is that Roth IRAs do not require you to take minimum annual distributions after you attain age 70½. If you designate a child or grandchild as the beneficiary after the deaths of you and your spouse, the child or grandchild will be required to take distributions over his or her remaining life expectancy. The potential for allowing funds to grow in a tax-free environment and be withdrawn over a long period of time makes a Roth IRA a fantastic asset to pass on to children and grandchildren.

If you convert to a Roth IRA, you are betting that the present value of the incremental after-tax distributions to you and your beneficiaries in the future is greater than the taxes you will have to pay at the time of the conversion. Whether paying tax now is a good bet depends on a number of factors including tax rates, and the ability of you and your heirs to keep the Roth IRA intact for a long time.

The analysis is complex. I plan to write several additional blogs regarding this topic in order to help you make this decision.

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