Converting IRA and Retirement Assets to a Roth IRAUnique opportunity in Divorce - Utilizing Roth IRAs The intent of this article is to educate the reader about increasing retirement income by converting traditional retirement plans (401k, IRA, 403(b), etc.) to a Roth IRA. While conversions (commonly referred to as "recharacterizations") can be beneficial to many taxpayers, there is a unique opportunity that often arises in the year of a divorce because of the timing of alimony payments. What are Roth IRAs? The Taxpayer Relief Act of 1997 created a new type of Individual Retirement Account ("IRA") named after Senate Finance Committee Chairman, Senator William V. Roth, Jr. Roth IRAs offer an unparalleled tax incentive - while contributions to Roth IRAs are not tax-deductible (unlike traditional IRAs), all distributions from a Roth IRA are tax-free. What are the Advantages? Similar to traditional IRAs, the dividends and interest generated by a Roth IRA, are not taxed while they are accumulated in the IRA. However, Roth IRAs offer a significant bonus - tax-free withdrawals. Although contributions are not tax deductible, withdrawals at age 59½ (earlier if you use it to buy a first home) are tax-free as long as it has been in the account for at least five years. And, there is no requirement to withdraw any money at age 70½; and, upon death, beneficiaries will not owe any income taxes upon withdrawal. Facts on Converting Traditional IRAs to a Roth IRA You can convert all or part of your traditional IRA to a Roth IRA. However, because contributions to a Roth IRA are non-deductible, you must pay tax on any taxable amounts you convert. The conversion is treated as a penalty-free premature distribution. Therefore, it must be listed on your tax return as taxable income, and that income could move you into a higher tax bracket. For 2010, conversion income can be reported 100% in 2010 or equally in 2011 and 2012. Signs for a Conversion Candidate While there are no hard and fast rules to identify conversion candidates, here are some "signs" to look for:
Tax Rates - What Does the Future Hold? To help make assumptions about the future of tax rates in the US, we can look backwards to see how rates have changed over time.
1918: Tax rates were raised to 77% in order to help pay for World War I. Tax rates started to fall in the years afterwards. Most economists agree tax rates will go up over the next 30 to 50 years. Even with that expectation, it is possible future taxes will not be income related, but rather consumption driven, like a Value Added Tax, which would not impact retirement plans. The Best Reason to Roth - the "Do Over" Incredibly, the tax code allows those that convert to later change their mind and "go back" to a traditional IRA before filing your tax return. This "do over" provision is potentially the most valuable in a volatile stock market. Here is an example of how this might work for the owner of a $200,000 IRA. The owner converts all $200,000 to Roth by opening 2 new Roth IRA accounts of $100,000 each at the beginning of 2010. The accounts are invested in different types of investments (US Large, Mid or Small Cap, International, Emerging Markets, etc.). On October 14th, 2011 prior to filing a tax return (but after filing for extensions), one account is valued at $85,000 and the other is worth $125,000. The owner can elect a "do over" on the $85,000 account, forgoing the tax on conversion, and providing an opportunity to convert again on January 1, 2012 - less than 3 months later. For the account with $125,000, the owner can keep the conversion, and pay tax on the $100,000 original amount. Conclusion If nothing else, it is worth reviewing your personal situation or that of your clients with an experienced financial professional or tax accountant to discuss the benefits of a Roth IRA conversion strategy. 2010 presents a unique opportunity because of the timing of tax payments (in 2011 and 2012) and the "do over" provision means there is nothing to lose by trying. Return to top of Converting IRA to Roth IRA in Divorce Copyright 2010
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