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

This is the fifth article in a series 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 6 – The Impact of Estate Taxes
Part 7 – Ramifications of Charitable Giving
Part 8 - Putting It All Together

Investment performance has extra significance during the first 21 months after a conversion to a Roth IRA. Your investment performance may determine whether you undo the conversion. The recharacterization option allows you to change your mind about a conversion as late as October 15 of the year following the conversion. This means that if you convert in January, you can make the Roth decision after seeing your investment returns over the prior 21 months.

The ability to make your decision after seeing your investment returns allows you to choose the maximum income tax rate that you are willing to pay. Assume that you are in a 35% income tax bracket and are only willing to make the conversion if the maximum tax rate on the conversion is 25%. This means that you will recharacterize the Roth IRA to a regular IRA unless the value of the IRA has grown by 40% during the first 21 months.

Unless you are a fantastic investor, there is a small likelihood of achieving a 40% rate of return on your entire portfolio over a 21 month period. However, you only need to obtain this return on a portion of your portfolio.

For example, assume that you convert an IRA with a value of $600,000 into six separate Roth IRAs with values of $100,000. You choose the overall investments for the Roth IRAs as if they were one account, yet place different asset classes in different Roth IRAs. Splitting your various asset classes into separate Roth IRAs increases the volatility of returns for each Roth IRA without increasing the risk of the overall portfolio. By increasing volatility, you significantly improve the chances of achieving a higher return on portions of your portfolio during the first 21 months.

Assume that the values of the six Roth IRAs after 21 months are $150,000, $130,000, $110,000, $100,000, $80,000, and $60,000. You will keep the two largest Roth IRAs and recharacterize the four with the lowest values. You will pay $70,000 of tax (35% times $200,000) on the two largest Roth IRA accounts with a combined value of $280,000. This represents an effective tax rate of 25%. The overall return on the portfolio was $30,000, which represents an aggregate return of 5%. However, by splitting the portfolio into its separate asset classes, you were able to achieve a much higher return on the portion of the portfolio that you converted.

Derivatives can be used to further increase the volatility among segments of your overall portfolio, without necessarily increasing the volatility of your combined portfolio. Though derivatives are frequently used by hedge fund managers, they are not utilized by many investors because they are less well understood and because they generally receive unfavorable income tax treatment when they are used in taxable accounts. The tax disadvantage is not a concern for Roth IRAs because Roth IRAs do not pay income taxes.

You will need to closely monitor your investments during the 21 month period following the conversion. On December 2 of the year of the conversion, you should consider recharacterizing accounts that have gone down in value. You can then reconvert on January 2 of the following year. On the other hand, if your investments do very well during the first months after the conversion, you might choose to shift the investment mix of the successful Roth accounts to decrease the risk of going backwards during the remainder of the 21 month period.  Similarly, you might shift investments to increase the volatility of accounts that are positive, yet not positive enough to keep the Roth IRA conversion. Ideally, any investment changes made during the 21 month period will maintain your overall desired portfolio allocation.

After the 21 month period, you can combine all of the Roth IRAs that you did not recharacterize and invest the combined Roth IRA account according to your long-term objectives. You will also need to coordinate the investments in your Roth IRA, your traditional IRA, and your taxable investment accounts.

The ability to decide about keeping a Roth conversion after seeing your investment returns will encourage a lot of investors to take a “free look.”  Careful planning with the assistance of your investment advisors is required to take maximum advantage of this tremendous opportunity.

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This is the fourth article in a series 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 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

If you convert to a Roth IRA, you are betting that the present value of incremental withdrawals by you and your family in the future are greater than the taxes you will pay at the time of the conversion. Future withdrawals will be maximized when you and your heirs keep the Roth IRA intact for a long time.

The first and most important hurdle for keeping the Roth IRA intact is whether you can pay the tax on the conversion from other assets. If you must use funds from the IRA to pay the tax, my advice is to not make the conversion.

The next hurdle is whether you and your spouse will need to take withdrawals from the Roth IRA. One benefit of Roth IRAs is that you do not have to take required minimum distributions during your lifetime. If you designate your spouse as the beneficiary following your death, your spouse can rollover the Roth IRA to his or her own Roth IRA. Your spouse will not have to take any distributions during his or her lifetime. Thus, if you and your spouse can meet your living expenses from other sources, you will never have to take a distribution during your remaining lifetimes.

The final hurdle is the time period over which your children (and/or grandchildren) will take withdrawals from the Roth IRA after you and your spouse die. They will be required to take distributions over their remaining life expectancy, determined under IRS tables at the death of the survivor of you and your spouse. For example, if the beneficiary is age 45, his or her life expectancy is 38 years.

Your beneficiaries will be eligible to leave the Roth IRA intact for a long time. However, imagine the temptation for the beneficiaries to make tax-free withdrawals to buy new cars or to take vacations. If you are concerned that your beneficiaries might take distributions for wants rather than needs, you can use a trust as the beneficiary of the Roth IRA. The Trustee would be required to withdraw the required minimum distribution and could withdraw more if the beneficiary needs more. In addition to slowing down withdrawals, the Trustee might add investment expertise that the beneficiaries lack.

Families that can meet spending needs from sources other than the Roth IRA have more to gain from converting a traditional IRA to a Roth IRA. If the Roth IRA will be liquidated relatively quickly, paying tax now is less likely to provide a benefit to your family.
 

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This is the third article in a series dealing with the topic of converting your traditional IRA to a Roth IRA. This article will examine the impact of income tax rates. For other articles, see:

Part 1 – Reasons to Consider the Roth Conversion
Part 2 – The Recharacterization Option
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 comparison of the income tax rate that will apply at the time of the conversion and the income tax rates that would apply to future withdrawals from your traditional IRA is the most important factor in helping you decide whether or not to make the conversion. The general rule is easy to state. If you anticipate your future income tax rates to be lower, converting to a Roth IRA is likely to be a poor choice. If rates will be the same or higher, converting is likely to be a good idea.

Judging by historical standards, the current top marginal income tax rate in the U.S. is extremely low. Since 1932, there have only been five years (1988-1992) where the top rate was lower than it has been for the period of 2003 through 2009.

 In light of the huge deficits that this country is facing, it seems inevitable that the highest marginal income tax rate will increase significantly. The top marginal income tax rate is currently scheduled to increase from 35% to 39.6% in 2011. The health care legislation that is currently being considered by Congress may include a surtax on the highest income taxpayers. We cannot tell for sure where rates are headed. However, there is a good chance that the highest rates will be increasing.

Not all wealthy individuals pay tax at the highest income tax rate. They may receive a lot of their income as tax-free interest on municipal bonds and tax-advantaged capital gains. Even if you are currently in the highest marginal income bracket, your income might decline in future years, especially if you are still working.

You need to keep in mind who will be paying the tax. It is reasonable for wealthy individuals to conclude that they and their spouses will always be in the highest marginal income tax bracket. However, if they only withdraw the required minimums, there will be a lot left in the IRA for their children. The children may not be in the top income tax bracket.

State income taxes should be considered. Tennessee does not impose an income tax on withdrawals from a traditional IRA. You might move to a state that imposes tax on distributions from a traditional IRA. It is more likely that your children will live in a state that imposes a tax on distributions from a traditional IRA.

You should also consider the possibility of leaving at least a portion of your traditional IRA to charity. If you are planning to make a bequest to charity upon your death, you should satisfy the bequest with a portion of your IRA. The income tax rate on distributions to charity from your IRA will be zero.

Even if income tax rates are highest in future years, this does not necessarily mean that you will benefit by converting. The conversion will likely force you into the highest bracket in 2010 because you will have the include the entire amount in your income for that year (or half in 2011 and half in 2012 if you make a deferral election).

The danger of higher income tax rates in the future will motivate a lot of people to convert at least a portion of their traditional IRA to a Roth IRA in 2010. Before you convert, you should consult with your CPA and other advisors to make sure that you are taking into account the myriad of factors that will determine the tax rates for you and your family if you do not make the conversion.
 

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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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A recent decision by the Tennessee Supreme Court (PDF) ruled that the entire increase in value of a 401(k) plan that occurs after marriage is a marital asset that is subject to equal division upon divorce. It does not matter whether the increase in value is attributable to appreciation of the assets that were held in the plan prior to marriage or contributions that were added to the account during the marriage. The pre-marital balance of the plan was separate property that was not subject to division.
 

The case confirmed that IRAs are treated differently. Appreciation of a pre-marital IRA that occurs during the marriage continues to be separate property and is not a marital asset subject to division upon divorce, unless the other spouse substantially contributed to its preservation and appreciation.
 

There are two lessons to be learned from this case. First, keep good records that demonstrate the account balance of the 401(k) plan on the date of your marriage. Second, if your 401(k) plan permits in-service withdrawals, you should establish an IRA, rollover your 401(k) to the IRA prior to your marriage, and exclude your spouse from making any investment decisions for your IRA.

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