Year-End Planning: Roth IRA Conversions
The purpose of Roth IRA conversions as it relates to the Net Investment Income Tax is to lower modified adjusted gross income below the threshold amount over the long-term. Some benefits of Roth conversions include lower overall taxable income, tax-free compounding, no required minimum distributions at age 70 ½, tax-free withdrawals for beneficiaries and more effective funding of the "bypass trust." Converting to a Roth IRA creates opportunities to reduce the overall size of the estate and to take advantage of greater tax-free yields and favorable tax attributes. Bob Keebler walks you through the mathematics of conversion through examples, tactical considerations and a four-step process for Roth conversion planning. Visit the AICPA PFP Section’s Post American Taxpayer Relief Act and NIIT Toolkit for more in-depth resources on planning in preparation for year-end.
This podcast was originally recorded Oct. 2, 2013.
ROBERT S. KEEBLER, CPA: On behalf of the Personal Financial Planning section of the AICPA, welcome to Year-End Tax Planning: Roth IRA Conversions. I'm Bob Keebler and I'll be your host today.
Why are we still talking about Roth IRA benefits so many years after the bill became law? Roth IRAs continue to be one of the most perplexing and powerful arrows in your quiver. They lower overall taxable income in the long term; of course, there's tax-free compounding. One of the beauties is no required minimum distributions at 70 1/2. There's always tax-free withdrawals for beneficiaries. And, certainly, more effective funding of the bypass trust.
In today's tax environment, especially with the volatility of the market, Roth IRAs should be one of the things you're talking to virtually every wealthy client about. The purpose of this strategy, at least as it relates to the net investment income tax, is to lower MAGI below the threshold amount over the long term.
Basically, there are a number of reasons to convert to a Roth IRA. Maybe your client has favorable tax attributes, including charitable carry-forwards, NOLs, high basis non-deductible IRAs. The suspension of the minimum distribution rules at 70 1/2 can really be a powerful tool for someone that doesn't need to spend the money. Taxpayers also benefit from paying the income tax before the estate tax. This is especially true in states like New York or Minnesota, where they have a much smaller exemption than at the federal level.
Now, if I have outside funds to pay my conversion taxes with -- in other words, I come to you with a $700,000 IRA but $300,000 in cash that I do not need, I am a really good candidate for a Roth conversion, much better than somebody that simple comes to you with a million-dollar IRA and no outside cash.
If I need to use the bypass trust when I die, that might be a very powerful tool. I may want to take a really good look at "Should I be funding my bypass trust with a Roth IRA rather than a regular IRA?” And I think this is especially efficacious in those states that still impose a state estate tax.
Now, there are four types of conversions. The strategic conversions, which are the ones we probably started looking at Summer of 1997. Those are the ones where you will run a lot of numbers and determine, over a twenty-year period of time, "How does a conversion impact a client's long-term wealth transfer objectives?"
Then there are tactical conversions. Take advantage of short-term specific tax attributes. I had a gentleman with me this morning that has over a million-dollar tax credit carryforward from low-income housing projects. And the issue becomes "How are those credit carryforwards available? How can we free those up to offset some income on a Roth conversion?” And you're probably well aware, it's somewhat difficult, but his CPA and I are working on that together.
Opportunistic conversions. We want to take advantage of short-term stock market volatility, sector rotation, rotation in asset classes. A lot of your clients should really look at doing conversions -- say, on January 1st, 2013 -- followed up by looking at what happens to those asset classes in the next 21 1/2 months and we'll talk about that.
Now, there are also hedging conversions. For example, if we found out that Congress was going to change to where one party controlled both houses of Congress and the White House, you might be inclined, if you thought tax rates would go up under that predicament, you would think -- you would say that you wanted to do Roth conversions. If you thought tax rates would go down under s different predicament, then what you would do is you might not do Roth conversions; these are all things to think about.
Now, in its simplest terms, a traditional IRA will produce the same after-tax results as a Roth, provided that the annual growth rates are the same and tax rates stay the same going forward. And we've learned this in about fifth or sixth grade.
Now, basically, if I have $1,000,000 in an IRA and that grows 200% by the time I die, I will leave $3,000,000 to my family. They'll lose 40% to tax and they'll have $1,800,000 left to spend.
In the alternative, if I do a Roth conversion today, funding the Roth conversion from -- with funds inside the Roth, taking the money out of the Roth to actually pay those taxes, then I'm going to have $600,000. Same mutual funds, now I have $1,800,000 when I die.
Conceptually, life insurance can also be a powerful tool, because, instead of doing a Roth conversion, maybe I take the money out, I pay the taxes and then I invest in life insurance. If I can earn a similar return, then I'm gonna have $1,800,000 there, too.
Now, what's very, very important is to know that, if somebody has an estate tax problem, they're probably more likely to look at life insurance than a pure Roth conversion. But 99% of our clients no longer have estate tax problems. They are going to have income tax problems and that's why the Roth IRA is so powerful.
Now, critical decision factors. We want to look at tax rate differential, year of conversion vs. withdrawal years. We also want to look at the use of outside funds to pay the annual income tax liability. We have to talk about the need for IRA funds to meet annual living expenses and, finally, time horizon. Okay? So these are all our critical decision factors.
Now, when you look at Roth conversions, generally, you want to stay in the same tax bracket, but, sometimes, you're gonna jump brackets. There is gonna be times when it makes sense to jump brackets. There's also gonna be time where it doesn't make sense.
And w- -- every time we look at a Roth conversion, we have to look at the impact of each of the different types of taxes. How does this impact the Medicare surtax? How does it impact the AMT? What about the 39.6% rate? And, finally, how is PE- -- how will PEP and Pease phase into this?
Now, that is -- that is five dimensions, when you include the regular income tax. Further, if we go a little bit further and you add in payment of Medicare premiums. Keep in mind that Medicare premiums will be more expensive as your income goes up, so you have to make sure clients understand that if you do a Roth conversion.
Now, there are many tactical considerations. If you have carryforwards. Sometimes you'll represent someone that's dying and they can do a Roth conversion before they die and burn up one of these carryforwards.
Now, one of the most important things is, when we used to do Roth conversions, we would look at someone converting 500,000 and we'd try to figure out exactly how that played out in the future; we do not do that any more.
What we would do, if a client came to you and said, "I want to do a $500,000 conversion," you would take out a chart like the one you have on the screen and you would show them that what we really want to do is a series of conversions adding up to $500,000. And, right now, you might be thinking, "Bob, what's the difference?” The difference is you want to measure the efficacy of each step on this -- on this ladder, okay? Measure each step. Why is that important?
Because maybe, at 25 and 28, a Roth conversion makes a great deal of sense; it's a positive. But maybe, once you get up to the 35 and 39.6, you're working backwards; it's hurting you. So what you do is maybe you just convert up to the top of the 28% bracket and stop, okay? Maybe we go up to where it says PEP -- the green arrow where it says "PEP," we stop right there before we start losing our itemized deductions. That -- those are numbers you have to crunch.
Now, the tool we use very often is the right to recharacterize. Under the regulations, basically, a Roth conversion. If you do a Roth conversion in one year, you're allowed to recharacterize up until October 15th of the following year. So you can choose to re- -- basically, you can choose to go back into a regular IRA; that's what a recharacterization's all about.
Now, the other thing you can do is if -- let's say you converted at a $100,000 and it fell to 85 and you recharacterized. Under the law, 30 days later -- and there's -- there's a double test here, but, generally, if you -- I convert in 2012 and I recharacterize today, 30 days -- 31 days from now, I would be able to jump back into the regular IRA -- or into a Roth IRA. And I -- if everything stayed the same, I would go in at $85,000, not at my original price of $100,000. Hence, I'm only paying income tax on 85,000, not on the entire 100.
Now, you are not allowed to cherry-pick and go into that IRA and say, "I converted five different stocks, three went up, two went down. I'll just leave the three that went up in the Roth.” Those would -- what would happen is they would tend to smooth each other out and you'd have to take the aggregate change of all five stocks.
But there's a nuance in the law. What the law says is, if you can identify -- by using separate IRAs -- each asset separately, then you're going to be able to -- the IRAs that have gone up in value you could leave in the Roth and the ones that have gone down, you're allowed to recharacterize if you so choose. This is -- therefore, it's important to set up a separate Roth IRA for each asset class.
On Page 16, I just have the timeframe for you. Basically, if somebody converted this year, in 2013, they would have until October 15, 2014, to potentially do a recharacterization. Bottom line is, if you convert in January, that gives you 21 1/2 months to evaluate what happened in the stock market, how did things change?
So what do we want to do? In general, if we're looking at Roth conversions, we start with a 10- to 15-year projection of income deductions and we compare these projections to the various taxes. Then we ask ourself the question, whether doing intrabracket conversions will hurt us, will they increase the 3.8% surtax, will they throw us into the AMT? How will they affect PEP and Pease? And how will they affect the 39.6% rate?
So, and then we want to look at developing a series of cross-bracket conversions. Every time you cross a bracket, that has to be measured autonomously, standing on its own. You have to take into account all the various taxes.
And then you keep repeating the above, based on the changes in the value and the opportunity to recharacterize. If someone came to me right now and said, "I want to do a $5 million Roth conversion," all we would do is convert by asset class and then, next October, we would evaluate how much of that we wanted to keep. That would be our key.
We've covered a lot of ground today. I -- it's important for us to know how supportive the AICPA Personal Financial Planning section's been. There's a thousand-page, four-volume guide for practitioners that's available. Also, Forefield Advisor has many good tools out there for us to use. Further, the AICPA has developed some of its own tools and, basically, there will be more information coming out in different toolkits that are being put together.
Finally, a number of seminars coming up this fall. And, if you can't make these seminars, they'll be taped, listen to the tapes on your own time and at a time that's convenient to you. Also, remember the AICPA's Personal Financial Planning Conference is in Las Vegas in January.
So, on behalf of the Personal Financial Planning section of the AICPA, this is Bob Keebler and thank you for joining us today.