Tax Topic: Roth IRA Conversions

There has been a lot of press regarding conversions, especially now that it is 2010 when the IRS is officially set to lift a provision that precludes tax-payers making more than $100,000 from converting their Traditional IRAs to ROTH. This opens the doors to a tremendous tax planning strategy to millions of Americans holding tax-deferred IRAs and defined contribution that has been out of reach for years. This may be even more compelling if plan assets are depressed in value.

One of the most attractive gems in the 2010 provisions is that you can defer tax payments if the conversion occurs this year (tax-payers making less than $100,000 have been able to convert but have had to pay taxes in the year of conversion). If a tax-payer converts this year they will owe half of the taxes on April 15th of 2012 and the other half on April 15th 2013.

If most of the Traditional IRA is made up of non-deductible contributions, the ROTH conversion makes a lot of sense. Also, if you expect to be in a higher tax bracket in retirement or expect to see a hike in overall tax rates (due to unprecedented government spending) then this strategy will work well. The main advantages are hedging against a rise in taxes, tax diversification (tax-free source of income in retirement), and estate planning (no minimum required distribution and spousal continuance).

A couple of things to look out for:
-If the conversion pushes the tax-payer into a higher tax bracket, this strategy may lose efficacy. Converting a partial amount that keeps in the same bracket is optimal.
-The taxes owed should not come out of the IRA, as there is a penalty on monies not converted. Taxes owed should come from existing taxable assets or savings.

This should be considered general guidance; a complete analysis of individual tax-payer situations should be done before acting on any strategy.

IRS Circular 230 Disclosure: This communication was written in connection with the promotion or marketing, to the extent permitted by applicable law, of the transaction(s) or matter(s) addressed herein by persons unaffiliated with Monoceros Capital Management, LLC. Monoceros Capital Management, LLC and its affiliates do not provide tax advice. Accordingly, to the extent this communication contains any discussion of tax matters, such communication is not intended or written to be used, and cannot be used, for the purpose of avoiding tax penalties. Any recipient of this communication should seek advice from an independent tax advisor based on the recipient’s particular circumstances.

Sources:
Financial Advisor Magazine, January 13, 2009 - Roth Conversion Rule Changes Will Help Many Advisory Clients, by Ben Norquist and Michael Slemmer
Internal Revenue Bulletin: 2008-12
fivecentnickel.com - Look before You Leap: Roth IRA Conversions in 2010
401kLookUp.com: Rules You Must Know to Convert a 401(k) to a Roth - IRS Notice 2008-30, Minimum Required Distributions on Inherited Roth IRAs & Restrictions for Beneficiaries, July 1, 2008
SmartMoney: New Math for IRA Savings by Peter Keating, April 1, 2009
Comparison of Roth 401k, Roth IRA, and Traditional 401k Retirement Plans by John E. Buckley, Economist, U.S. Department of Labor