Roth IRAs In 2010

ROTH IRAs in 2010Advanced Conversions Strategies

Leon C. LaBrecqueJD, CPA, CFP®,CFA

LJPR, LLC Reducing Uncertainty™

Outline

• Roth Basics• Contribution and Conversions• Planning With Roth conversions• Segregated Roth Conversions

– Vertical Segregation– Horizontal Segregation– Matrix segregation

• Estate Planning

Roth Basics

• Three types of IRAs:– Deductible (contributions and income is tax-deferred)– Nondeductible (income is tax-deferred)– Roth (income is tax-free

• Roth, Roth 401(k) (DRAC)• Roth is tax-free on qualifying distributions

– 5 year or age 59 1/2 , or– Death, disability, qualifying special purpose

distribution

Roth Basics

• No Required Minimum Distributions• Conventional IRA investment choices (virtually

unlimited)• Qualifying Roth distributions excluded form:

– Taxation of Social Security benefits– Medicare Part B premium need based calculation

• FIFO withdrawals• Earned Income requirement for contributions

Contributions

• Lesser of earned income or:– $5,000 (under age 50)– $6,000 (turning 50 or older in year of contribution)

• AGI Limits– MFJ: $166,000 - $176,000 (phase out)– Single: $105,000 - $120,000 (phase out)

• AGI Limit Loophole: Nondeductible IRA for 2009 and 2010, then convert

• Rollovers from 401(k), 403(b) and 457 allowed

Conversions• Existing Traditional IRAs can be converted to Roth

by paying the tax on the fair market value of the taxable portion.

• Beware of tax bracket creep.• Conversions can be recharacterized (so can

contributions)• 2010 conversions have no income limit• 2010 conversion have two tax options:

– Pay all tax in 2010– Split income equally between 2011 and 2012

To Split or Not to Split?

• Splitting is automatic: you have to split income on Roth conversions in 2010 unless you elect otherwise by paying the tax.

• If your income and rates stay the same, you save taxes by splitting.

• Example: Married Couple over 65, standard deduction. They have income in 2010 of $89,900 before any Roth conversion. They convert $300,000 in 2010. They can elect to pay the entire tax on the conversion in 2010, which would be $93,219. Otherwise, they would split the taxes over 2011 and 2012 and pay $40,380 in each year. This saves $12,459 in taxes, plus the time value of money, since they pay no taxes on the conversion in 2010, and spread the $40,380 over the next two years.

Recharacterization• Tax Mulligan. You can reverse a conversion by

putting the funds back into a traditional IRA.• Can recharacterize once a year (30 day rule),

per Roth conversion.• Timeline for recharacterization:

– 10/15/11 for 2010 conversions if return is timely filed or extended;

– 04/15/11 for 2010 conversion if return if filed late and not extended.

Who should convert?

• Taxpayer in same or higher bracket at distribution time:– Other income sources– RMD considerations

• Taxpayer’s Heirs– Spouse (RMD and filing status)– Children and grandchildren

• Estate Tax situation• Unneeded RMDs

RMDs

• Roth's are not subject to RMD.• RMD calculation has a decreasing

denominator.• RMD shift the taxpayers bracket higher if the

rate of return is higher than the initial withdrawal rate.

• RMD if unneeded are merely a tax burden at the highest marginal bracket.

Higher Brackets• Taxpayers can be in a higher bracket by virtue of RMDs• The death of on spouse leaves the other in the higher single

bracket• Example: Older couple, C&D, over 70 ½, same age. Have

income consisting of primarily IRA distributions from their rollover IRAs, plus Social Security. Income for both, with Social Security is about $156,000. They take standard deduction. Total Federal tax is $26,687. C dies, D loses C’s Social Security of $15,000 (taxable portion). D’s income drops to $141,000. However, now she is single (lower standard deduction, one less exemption and higher bracket). Her tax would go up to $30,571; $3,887 more. Roth conversion helps the surviving spouse.

Higher Brackets: Kids

• Another scenario is the parent in low bracket with successful kids in higher bracket.

• Example: mom or dad with basic pension and Social Security. RMDs are unneeded and also are forcing the Social Security to be taxed (possible need-based Medicare B as well). Kids are in high brackets. Convert and reduce taxes, plus pass tax-free annuity to kids.

• Don’t forget grandkids (and don’t forget GST)

Estate Tax

• Current estate tax situation requires a food taster for the well-off. (No tax in 2010, the $1M and 55% in 2011)

• Probably outcome is a $3.5M exclusion and 45% rate (possible $5M and 35%)

• Roth conversion reduces estate taxes by the income tax paid on the conversion

Estate Tax Example• Bill has an estate worth $4M, of which $1M is in

an IRA. He dies (and estate exclusion goes to $4M), leaving estate to kids. Kids pay $225,000 of estate taxes and income taxes on the $1M IRA (with a prospective income tax deduction of IRD of $225k). If he converts IRA to Roth, he pays $350,000 in income taxes. Estate taxes are only $67,500 and kids get $1M IRA tax-free. $531,900 total taxes (if kids are in upper bracket) on traditional IRA, versus $417,500 with Roth conversion.

Segregated Roth Conversions

• Multiple Mulligan opportunities by converting multiple Roth’s.

• Recharacterization can only be done once a year, so having multiple Roth IRAs allows for selective recharacterization.

• Vertical segregation would allow asset picking– Individual securities– Asset classes

Conversion Example

Traditional IRA280,000

Roth Conversion IRA

02/03/10

Roth Conversion IRA

308,000

12/10/10

One Roth worth $308,000No recharacterization,

tax on $280,000. $28,000 tax-free gain

Segregated Example

Traditional IRA280,000

LC$42,000

02/03/10 12/10/10

6 Roth's worth$ 248,800, 2 recharacterizations, tax on $210,000. $38,800 tax-free gain

IGF$28,000

SC$42,000

GFI$28,000

ILC$42,000

FHY$28,000

EM$42,000

EMI$28,000

LC$51,000

IGF$29,400

SC$52,000

GFI$29,400

ILC$52,000

FHY$33,000

EM$34,000

EMI$25,200

EM$34,000

EMI$25,200

Layered Roth• Set up ‘base layer’ of amount necessary to

recharacterize to original amount under ideal market gain [1.00/(1.00 + i)].

• Multiple Roth ‘layers’ of market gain intervals• Example:

– 80% base layer– Eight 2.5% market layers– Market goes down, recharacterize all and try next year– Market goes up, leave appropriate layer in Roth,

recharacterize rest

Layered RothMarket goes down 5%

Traditional IRA $1,400,000

Roth Base$1,120,000

Layer 1 35,000Layer 2 35,000Layer 3 35,000Layer 4 35,000Layer 5 35,000Layer 6 35,000Layer 7 35,000Layer 8 35,000

Traditional IRA $1,330,000

Roth Base$1,008,000

Layer 1 33,250Layer 2 33,250Layer 3 33,250Layer 4 33,250Layer 5 33,250Layer 6 33,250Layer 7 33,250Layer 8 33,250

Recharacterizeall, IRAs no taxes

Layered RothMarket goes up 10%

Traditional IRA $1,400,000

Roth Base$1,120,000

Layer 1 35,000Layer 2 35,000Layer 3 35,000Layer 4 35,000Layer 5 35,000Layer 6 35,000Layer 7 35,000Layer 8 35,000

Traditional IRA $1,386,000

Roth Base$1,232,000

Layer 1 38,500Layer 2 38,500Layer 3 38,500Layer 4 38,500Layer 5 38,500Layer 6 38,500Layer 7 38,500Layer 8 38,500

RecharacterizeBase and layers

1-4, leaves $1,386,000 back in

Traditional, leave gain of $154,000

in Roths 5-8, tax on $140,000

Layered RothMarket goes up 25%

Traditional IRA $1,400,000

Roth Base$1,120,000

Layer 1 35,000Layer 2 35,000Layer 3 35,000Layer 4 35,000Layer 5 35,000Layer 6 35,000Layer 7 35,000Layer 8 35,000

Traditional IRA $1,400,000

Roth Base$1,400,000

Layer 1 43,750Layer 2 43,750Layer 3 43,750Layer 4 43,750Layer 5 43,750Layer 6 43,750Layer 7 43,750Layer 8 43,750

RecharacterizeBase, leaves

$1,400,000 back in Traditional, leaves gain of $350,000

in Roths 1-8, tax on $280,000

Matrix Roth

• Combine strategies:• Set up base layer, allocated as you like it (less

allocation to layers).• Segregate the layers into asset classes with

most volatile assets in each layered Roth.• Recharacterize the losers• Recharacterize the base layer

Matrix RothMarket goes up 10%

Traditional IRA $1,400,000

Roth Base$1,120,000

LC $42,000IGF $28,000SC $42,000GFI $28,000ILC $42,000CHY $28,000EM $42,000EMI $28,000

Traditional IRA $1,383,000

Roth Base$1,232,000

LC $51,000IGF $29,400SC $54,000GFI $29,400ILC $52,000CHY $33,000EM $34,000EMI $25,200

RecharacterizeBase and layers

1-4, leaves $1,386,000 back in

Traditional, leave gain of $157,000in Roth's, tax on

$126,000

Comparison of Strategies10% Market gain

• No segregation, $140,000, Tax on $140,000, Roth worth $154,000 ($50,400 tax, $14,000 gain). Base IRA is $1,386,000

• Vertically segregate $140,000, selectively recharacterize: Tax on $105,000 Roth's worth $124,400 ($37,800 tax, $19,600 gain). Base is $1,415,000

Comparison: 10% market gain

• Layered Roth: Segregate layers, recharacterize all but upper layers, Roth's worth $154,000, basis is $140,000 ($50,400 tax, $14,000 gain) Base IRA is worth $1,386,000.

• Matrix Roth: Segregate asset classes, recharacterize any class lower than market gain, Roth's worth $157,000, basis is $126,000 ($45,360 tax, $31,000 gain) Base IRA is worth $1,383,000.

More Estate Issues

• Roth conversion provides a tax-free annuity for children or grandchildren

• GST could be minimized or eliminated with an IRA trust– Accumulation trust– Income trust– Formula in Trust

• Charity illogical• QDOT

What Can Go Wrong?

• Congress could eventually tax Roth's– Necessity of proactive law– Income tax– VAT or excise tax would tax distributions (and

everything else) on consumption• Congress could prohibit or limit conversions