Friday, November 20, 2009

The Roth of Con(versions)

Tax Increase Protection and Reconciliation Act of 2005 (TIPRA)

TIPRA has a forward-looking provision regarding Roth conversions. It repealed the MAGI limit of $100,000 for 2010 and beyond on conversions. The contribution limits remain intact.
TIPRA also provided for a special tax treatment of Roth Conversions made in 2010. Unless a taxpayer elects otherwise, income from the conversion is taxed over a two-year period, beginning in 2011. So, if a taxpayer converts $100,000 of Traditional IRA money to a Roth IRA in 2010, he will add $50,000 to his tax return for the 2011 tax year, and $50,000 to his tax return for the 2012 tax year. If the taxpayer elects, he may add the entire $100,000 to his tax return for the 2010 tax year.

Cents and Sensibilities

The feasibility of a Roth Conversion depends on tax rates at the time of conversion, tax rates at the time of distribution, availability of funds to pay the taxes, expectations of portfolio growth, and likelihood of passing the account to non-spouse beneficiaries. Many of these factors are unknown; a decision needs to be made based on reasonable expectations. By evaluating the following questions, a Traditional IRA owner can to determine what the practical approach is:
  1. Will tax brackets rise after 2010?
  2. Will tax brackets remain above current rates for an extended period of time?
  3. Do you expect the account balance to increase meaningfully during 2010?
  4. Do you have non-retirement funds that you can use to pay the tax liability upon conversion?
  5. Will the Roth IRA likely survive both you and your spouse?; also,
  6. Will Congress initiate new taxes in 2010 that will be retroactive?
  7. Will a conversion trigger Alternative Minimum Tax or other surtaxes, or will it accelerate the phase-out of deductions and exemptions?
The more confident the taxpayer is that the answers to questions 1-5 are "Yes" and the answers to questions 6 and 7 are "No," the more confident he can be that a conversion early in 2010 would be practicable. The taxpayer should also consult his tax advisor before committing to any conversion.

To Bifurcate or Not To Bifurcate, That Is the Question

Assuming we convert to a Roth IRA in 2010, we have a choice of when to pay taxes. For conversions that occur in 2010 only, the taxpayer may pay the tax liability by April 15th, 2011, or they can add one-half of the converted amount to the tax return they file by April 15th, 2012 and the other half on the tax return they file by April 15th, 2013.
At first blush, you would think that we want to defer taxes until later. However, we are making the conversion in the first place to take advantage of the known lower tax rates currently in effect. Things are not as they seem—it is, as if, something is rotten in Denmark (or D.C.).
First off, converting to a Roth IRA becomes more advantageous if tax rates rise. Whether we pay the tax from the IRA or not, we are in essence betting that taxes will go up. Taxes are at historically low levels. Many political and economic pundits say that ballooning deficits will put pressure on the Government to raise taxes.
Secondly, the current tax law expires on December 31, 2010. Unless Congress acts, tax rates will return to 2006 levels on January 1, 2011. Tax brackets shift from the current 10%, 15%, 25%, 28%, 33%, and 35% rates to 15%, 28%, 31%, 36%, and 39.6%. Taxes on capital gains and dividends will rise, and certain credits will cease or be reduced.
Barring the unknown of Congressional action, we know the tax structure will be higher in 2011 and 2012 than it is in 2010. Unless a taxpayer knows that his taxable income will be significantly lower in the latter years, it makes sense that he pay taxes on the conversion in 2010. (As a broad supposition, if many taxpayers convert great amounts of IRA dollars and choose to pay the tax with their 2010 returns, it may ease the pressure on Congress to raise taxes in 2011 or 2012 beyond the de facto increases in place.)

Diversify, Diversify, Diversify

Investment advisors recommend that we diversify across asset classes to reduce purchasing power risk. They recommend we diversify within asset classes to reduce systematic risk. They recommend we diversify among banks and insurance companies to reduce unsystematic risk. We now have an opportunity to diversify among taxable, tax deferred and tax favored ownership to reduce income tax risk.
We know that mechanisms are in place to change taxes in the future, as they have changed over the past 100 years. Tax deferred assets such as qualified plans and IRAs are exposed to future tax risk. Taxable assets are exposed to both current tax risk and future tax risk. Roth IRAs (and their similar ownership forms such as 529 plans) are exposed to current tax risk, but avoid future tax risk—barring an outlying event such as a retroactive tax law change. As our assets accumulate in tax deferred ownership, we become over-weighted in future tax risk. Roth IRA conversions allow us to diversify this risk, just as we attempt to diversify to reduce the other risks.