Should You Convert to a Roth IRA? (Part 4)

Should You Convert to a Roth IRA? (Part 4)

I can now firmly tell you that this will be a 5-part series on converting to a Roth IRA. Our goal is to explain the essential points that you, as an investor, must understand and consider as you decide whether or not converting to a Roth IRA will benefit you and your family. Today, we will further discuss the tax implications surrounding these conversions.

 Can I undo a Roth conversion?

Yes, it is possible to undo a Roth conversion through something called a “recharacterization,” which is essentially a “reconversion” to qualified status. Typically, you have until October 15 of the year after a conversion to do a recharacterization.

So if Vickie converted her traditional IRA to a Roth IRA on January 5, 2010, she has until October 15, 2011 to change her mind and undo it.

Will I incur a 10% “early withdrawal” penalty by converting my qualified funds if I am younger than 59½?

Converting to a Roth IRA grants you an exception to the 10 percent early withdrawal penalty rule. That is, unless you withdraw funds from your existing qualified plan to pay the taxes on a conversion, which is considered a distribution and will, therefore, incur income tax plus a 10 percent penalty if you are younger than 59½.

Let’s say Ted is 55 years old and has $150,000 in a 403(b) from his previous employer. If he converts the entire amount to a Roth IRA, he’ll owe income tax but have to pay no penalties, even though he’s not yet 59½.

However, if Ted were to convert only $100,000 and withdrew the remaining $50,000 to pay the taxes due, he would owe income tax on the entire $150,000. In addition, he’d have to pay the 10 percent penalty on the $50,000 because that would be considered a distribution, not a conversion.

After converting to a Roth IRA, do all withdrawals automatically become income-tax free?

It is critical that you pay very close attention to the various situations I describe here, as I have personally noticed and encountered a great deal of misinformation in this area.

• Regardless of your age, you may withdraw your principal – the initial after-tax funds that went into the Roth account – anytime, without an income-tax hit or a penalty.
• However, regardless of your age, you will be taxed on any gains you withdraw within the first five years of the conversion.
• If you are younger than age 59½, you will also pay an additional 10 percent penalty tax on any such gains that you withdraw within the first five years of the conversion, except in the case of certain specifically allowable exceptions.
• Once the converted funds have been held in the Roth IRA for more than five years and you are older than age 59½, all the gains in the account become income-tax and penalty free. Yeah – finally!
• Note, however, that even if you have held the account for more than five years but are younger than 59½ years, your gains will be taxed in addition to the 10 percent penalty, except in the case of certain specifically allowable exceptions.

What Are the Specifically Allowable Exceptions?

Generally, when funds are accessed in any of the following instances, they are considered exceptions:

• Death or disability of the owner
• Medical expenses
• Health insurance premiums for the unemployed
• Qualified higher education expenses
• Qualified first-time home purchase
• Substantially equal periodic payments
• IRS levy

In such instances, the 10 percent penalty tax is waived. However, the income-tax on the gains is not waived except in the case of the death/disability of the account owner OR for a qualified first-time home purchase and the account has been held for more than five years.

In the final post in this series, I’ll offer my professional opinion on whether or not you should convert to a Roth IRA, so I’m sure you won’t want to miss that!

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For your free, no-obligation, comprehensive analysis to determine whether it even makes sense for you to consider a Roth conversion, call (301) 949-4449 or schedule your appointment here.

Should You Convert to a Roth IRA? (Part 3)

Should You Convert to a Roth IRA? (Part 3)

I must reiterate that I am not quite sure how long this series will end up being. My intention is to discuss the salient points that you, as an investor, must understand and take into consideration as you decide whether or not converting to a Roth IRA is something that will benefit you and your family. Today, we will begin tackling the tax issues surrounding these conversions.

How Is One Taxed on the Amount Converted?

The answer to this question depends on whether the contributions were made with deductible (pre-tax) or nondeductible (after-tax) funds.

Accounts With Deductible Contributions ONLY

Since the contributions, as well as growth up until the time of the conversion, have never been taxed, the entire converted amount is considered ordinary income in the year of the conversion. There is a special 2010 only exception which I’ll discuss shortly.

By way of an example, say Peter used to work for XYZ Inc. and participated in the company’s 401(k) program by making pre-tax contributions. His 401(k) balance is presently $100,000. Peter is no longer employed at XYZ and now wishes to convert the $100,000 into a Roth IRA in 2010. The entire $100,000 will be added to his income for this year (assuming he’s not using the special exception). However, his taxes will be based on the applicable rate, depending on his taxable income.

It is hugely important that you pay close attention to my choice of words here. As I pointed out in my book, 5 Mistakes Your Financial Advisor Is Making, mistake #1 is still being made by tons of so-called financial advisors/experts: perpetuating the myth that your income always depends on how much money you earn.

Here’s what I mean. Say Peter talks to a savvy strategist from Laser Financial Group, who helps him create legally allowable income offsets to reduce his $100,000 gross conversion income down to $50,000, or completely eliminates any taxable income. Peter would then owe tax on the lower amount ($50,000 or zero), instead of the full $100,000. We continue to help numerous clients to achieve similar results.

Accounts With Nondeductible Contributions ONLY

Such funds will owe tax only on the growth up until the time of conversion. Say Mary contributed $50,000 to a traditional IRA but did not deduct any portion of the contributions for tax purposes. If that IRA now has a balance of $70,000, she will owe tax only on the $20,000 gain. Again, it is important to consider the possibility of reducing or even eliminating those tax consequences.

Accounts With BOTH Deductible and Nondeductible Contributions

The law demands that taxes are paid on a “proportionate share” of the conversion. But what does this mean?

Assume that Katie’s traditional IRA is currently worth $100,000, and $10,000 of her contributions were after-tax. Katie decides to convert $10,000 to a Roth IRA. Only 10 percent (in this case $1,000) of this $10,000 will be tax-free, meaning she will be taxed on 90 percent (or $9,000). By law, 10 percent of the account is tax-free, so 90 percent of the funds released are taxable. If Katie really wants to withdraw all $10,000 tax free, she’ll need to convert the entire $100,000 and pay tax on 90 percent ($90,000). Interesting, isn’t it!

What Is the Special 2010 Exception?

NOTE: This arrangement applies ONLY to conversions completed in 2010. For such conversions, you may decide to either pay ALL of the taxes due in 2010 or split the amount converted – not the taxes due – EQUALLY between 2011 and 2012. These are the only options and they are non-negotiable.

Remember Peter from the earlier example, who wishes to convert $100,000 in 2010? He may recognize the full $100,000 as income in 2010 or include $50,000 as income in 2011 and $50,000 in 2012. However, he cannot do the 50/50 split for 2010 and 2011 – yes, the law is that rigid.

Here is something you must consider as you decide whether to convert your retirement income to a Roth IRA. If you choose to do the 50/50 split in 2011 and 2012, your taxes will be based on your applicable rates in 2011 and 2012, not 2010 rates. As you may already know, the 2001 tax-cuts are due to expire at the end of this year, which means it behooves you to ponder where YOUR future rate is headed, beginning in 2011.

Look for more conversion-related tax information in Part 4 of this series. And if you’ve missed the other segments in this series, read them here:

  Part 1

  Part 2

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Interested in converting your IRA/401(k) with little or possibly no tax consequences, like our clients have done and continue to do? Or do you simply need some advice deciding whether it even makes sense, given your situation, to convert? Please call (301) 949-4449 or visit our website to schedule your free, no-obligation consultation.

Should You Convert to a Roth IRA? (Part 2)

Should You Convert to a Roth IRA? (Part 2)

As I pointed out in my most recent blog, I am not quite sure how many parts this series will end up containing. My intention is to discuss the salient points that you, as an investor, must understand and take into consideration as you decide whether or not converting to a Roth IRA is something that will benefit you and your family. As a result, I will focus on only one or two areas per blog post.

This is what I know for sure: You will receive factual information presented in a clear, simple, unbiased manner.

Is It True That Only Traditional IRAs Can Be Converted?

There seems to be a lot of misinformation out there, one of the significant distortions being that you must first convert your investment into a traditional IRA, and then into a Roth. In reality, basically any qualified plan may be converted. Qualified plans are those into which you deposit before-tax dollars and defer taxes on the growth as well. Examples include traditional IRAs, 401(k)s, 403(b)s, and tax-sheltered annuities.

Must My Employer Allow Me to Convert My Work-Related Funds?

Although the law permits you to convert and you may want to, your employer’s retirement plan policy supersedes everything else. Most employers’ policies do not allow the transfer of retirement plan funds while you are still employed by that establishment.

For instance, say George has accumulated $400,000 in his employer’s qualified 401(k) program. Now George wants to convert all or a portion of his funds to a Roth IRA; however, his employer’s policy does not allow any transfers unless he is no longer employed at the firm. That’s tough luck for George unless, of course, he resigns.

How Is the Transfer Made?

The transfer can happen in one of two ways:

1. You may request that your current fiscal custodian transfer the funds directly to a new Roth custodian.
2. You may request that the funds first be released to you, and you then turn them over to your new Roth custodian. However, if you use this indirect approach, the new account must be set up and the money deposited into it within 60 days.

Are There Minimum and Maximum Amounts That Can Be Converted?

The amount you convert is completely up to you. You alone make that decision. The “new” law is not an all-or-nothing situation. I must tell you, though, that most investment firms require their own minimums to maintain an account with them, but those limits have nothing to do with the law. And I can virtually guarantee that you needn’t worry about the maximum amount.

Say Sarah has $100,000 in her traditional IRA. She may decide to convert $5,000, $10,000, all $100,000, or any amount in between.

Is 2010 the Only Year That Such Conversions May Take Place?

As the law stands now, you may convert beyond 2010. Of course, just like any other laws, Congress may suddenly decide to change or repeal it at any time. More to the point, this is one of the primary areas where investors are receiving misinformation and being rushed into making decisions, some of which are not financially savvy.

As I laid out in Part 1 – please read it if you have not done so already – these conversions have been available for the past 13 years, so any advisor who is behaving as if you are doomed if you don’t do it now is, frankly, projecting a false sense of urgency, and I would be very careful dealing with such folks. The more interesting and more important question is where has your advisor been all these years?

Having said that, as a retirement planner, I understand the power of time and compounding, so I’d want my investors to take advantage of good opportunities that will enhance their wealth as soon as possible, BUT only after performing proper due diligence.

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If you would like FREE assistance in determining how YOUR numbers play out in your decision-making process, call us at (301) 949-4449 to give us some quick information, and we’ll send you a year-by-year analysis of YOUR numbers.

Should You Convert to a Roth IRA? (Part 1)

Should You Convert to a Roth IRA? (Part 1)

You may have received materials about them in the mail, seen or heard about them in the mass media, or had your advisor contact you about them — the 2010 Roth Conversions that financial professionals are madly marketing as “America’s new tax break,” when, in fact, it really isn’t new at all.

For the next few posts, I intend to bring you certain facts that I believe you, as an investor, must know, understand, and definitely consider before taking the Roth leap, if you even find it necessary at all.

What Is a Roth Plan?

The general premise of Roth plans — as opposed to qualified plans — is that you contribute after-tax (nonqualified) dollars today and can access those funds later (including any gains) tax-free, provided you meet certain conditions which are laid out in the tax code.

All things being equal, given the fiscal climate of our nation and the bad tax planning advice most Americans receive when preparing for retirement, the Roth premise is better than traditional qualified plans for maximizing spendable income. I explain this in greater detail in two of my books, 5 Mistakes Your Financial Advisor Is Making, and Is Your 401K a Trap? If you haven’t already done so, please download your free copy!

Suddenly I’m realizing that pretty much out of nowhere, almost every financial advisor/expert now agrees with the common-sense concepts and strategies I have been promoting and implementing for my clients over the past decade or so. I wish they could have done so earlier, but it truly is better late than never.

So, What Is This “New” Stuff?

Congress passed a law called The Tax Increase Prevention and Reconciliation Act of 2005 which eliminates the $100,000 modified adjusted gross income (MAGI) limit on Roth IRA conversions in 2010 and beyond.

PLEASE NOTE — Until the passage of the new law, you were allowed to convert qualified funds only if your MAGI (before income from the conversion) was $100,000 or less, regardless of whether you were single or married.

MAGI is calculated by adding back certain items to your Adjusted Gross Income (AGI), which can be found on line 38 of your Form 1040; or line 22 of your Form1040A:

* Traditional IRA contribution deductions

* Student loan interest deductions

* Tuition and fees deductions

* Domestic production activities deductions

* Foreign income or housing costs excluded on Form 2555

* Foreign housing deductions taken on Form 2555

* Savings bond interest excluded on Form 8815

* Adoption benefits from an employer excluded on Form 8839

If Your MAGI Is $100,000 or Less

If your MAGI totals $100,000 or less, you have been able to convert your qualified dollars since the introduction of Roth IRAs in 1997. Meaning this new law changes nothing in your situation. Here’s the thing, though: most Americans’ MAGIs have always been and still continue to fall below $100,000.

Those With a MAGI of $100,000 or More

Now, if your MAGI is $100,000 or more, you also could have achieved the same general benefits of Roth IRAs by maximum-funding an investment grade life insurance contract within the confines of sections 7702 and 7702A of the Internal Revenue Code. You see, under those rules — regardless of your gross income, AGI, or MAGI — you many contribute any amount you want, and I mean ANY amount, and have access to those funds (including any gains), tax-free. Even better is that you do not have to wait 5 years and also be age 59½ in order to enjoy the tax-free access. Now that’s sweet — even better than a Roth, if you ask me.

So if your financial advisor really knows their industry, America’s “new” tax break is, in reality, nothing new.

Here Are the Real Questions

1. If the Roth principle is a preferable option for investors (including you) — my clients and I agree that this is true in most cases — why did your financial advisor delay making such a suggestion until now? This is 2010 — it’s been 13 years since Roths were introduced! One can logically suggest that certain so-called advisors don’t know what they don’t know, or they just don’t care. But since they are supposed to care, my only logical conclusion is that they’ve been living on Mars until now.

2. Can someone offer a sensible explanation as to why these same advisors are still encouraging younger investors to fund qualified 401(k)s, 403(b)s, 457s, and tax-sheltered annuities? Don’t they realize that they are literally building retirement-tax bombs, since these same so-called experts are, ironically, predicting an increase in future tax rates?

Look for Part 2 in next week’s post.
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To fully CONTROL your wealth, call us at (301) 949-4449 or schedule your free, no-obligation consultation.