ROTH CONVERSION STRATEGIES FOR HNW AND AFFLUENT HOUSEHOLDS

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1 LEARNING CENTER KNOWLEDGE + KNOW-HOW WHITE PAPER ROTH CONVERSION STRATEGIES FOR HNW AND AFFLUENT HOUSEHOLDS Roth conversions can allow high-net-worth (HNW) investors 1 to acquire material amounts of Roth retirement assets. Although high income level restrictions 2 still prevent many HNW investors from making annual contributions, the income restriction for conversion eligibility (i.e., modified adjusted gross income greater than $100,000) was removed. This allows HNW investors to acquire material Roth account balances by converting eligible and workplace retirement plan assets to Roth assets. Because there are many issues investors need to consider before executing Roth conversions, careful planning and coordination with tax advisors, estate planners and financial advisors is critical. Background Prior to 2010, investors could not execute a Roth conversion if their modified adjusted gross income (MAGI) exceeded $100,000 or if they were a married individual filing a separate tax return. Washington has since repealed those restrictions. Conversion options include: -to- conversion Retirement plan to conversion Retirement plan in-plan conversion to a designated Roth account Investors with traditional, simplified employee pension (SEP) or savings incentive match plan for employees (SIMPLE) s or distributable retirement plan assets (e.g., defined contribution, defined benefit, 401(k), 403(b) or governmental 457(b) plan assets) may convert all or a portion of these assets to a. Investors who have 401(k), 403(b) or governmental 457(b) plans may have the ability to convert plan assets to designated Roth accounts within the plan. How is the tax impact of a conversion computed? If the conversion involves an -to- conversion (traditional, SEP or SIMPLE), then the investor, working with his or her tax advisor, would compute the additional taxable income from the conversion using IRS Form The IRS treats an conversion as consisting of a pro rata share of pretax and after-tax dollars, based on the pretax and after-tax ratio of assets in all of the investor s s combined. The greater the portion of nondeductible (or after-tax) assets in the investor s traditional, SEP and SIMPLE s, the less the tax burden of a Roth conversion. If the conversion is an in-plan conversion within a workplace retirement plan, the plan administrator must report the taxable and nontaxable amounts of the conversion on IRS Form 1099-R. The greater the portion of after-tax assets in the conversion amount, the less the tax burden to the plan participant. assets and assets from other qualified retirement plans of a participant who is conducting a conversion are not aggregated to determine the taxable and nontaxable amounts of a plan conversion. 1 Households with annual income in excess of $100,000 2 Greater than $132,000 for single tax filers and $194,000 for couples filing a joint tax return for 2016

2 Tax liability based on combined assets Total number of s you own $100,000 total assets Convert $10,000 Calculate tax liability $9,000 taxable at conversion *Ratio applies regardless of account or amount used for conversion. For retirement plan-to- conversions, a special rule in IRS Notice allows an investor to select how the pretax amount is allocated when the withdrawal is sent to multiple destinations. Plan participants may direct the distributing plan administrator to send the pretax portion of a withdrawal to a traditional and the after-tax portion to a, with the result being a tax-free direct rollover to the and a tax-free conversion to the. If the plan participant directs the entire amount to the, then he or she would have to include the amount of any pretax assets converted in his or her taxable income. What HNW clients need to consider In addition to potentially incurring a large tax bill as a result of a Roth conversion, investors, especially those in HNW households, have other important considerations, including: Key conversion consideration #1: Where will the money come from to pay taxes? Because a conversion may be a taxable event, a key consideration is how the investor will meet the increased tax obligation that may result from a conversion. Generally, it is not advisable to rely on additional or retirement plan assets to pay the tax liability resulting from a conversion. There are strategies to minimize the tax impact of a conversion. Some of these strategies are covered in the Learning Center white paper titled, and Employer Plan Strategies That Lead to Roth Assets. Key conversion consideration #2: What estate tax implications might a conversion have? Another key consideration is how the income tax obligation resulting from the conversion compares with potential estate tax obligation. The executor of a decedent s estate must include the value of the decedent s s and retirement plan assets in the individual s gross taxable estate. Each person has a unified credit that he or she can use to offset gift tax during his or her lifetime and estate tax upon death. In a Roth conversion, income taxes paid as a result of the conversion reduces the decedent s gross taxable estate. For example, if a decedent s gross taxable estate is projected to exceed the exclusion amount ($5.45 million for 2016) so that the executor of the estate must pay federal estate tax, then a conversion could offer the estate a tax benefit as illustrated in the example below: Example Tom, who is a HNW investor in the 39.6% tax bracket, converts $1 million to a in The income tax on the conversion is $396,000 ($1 million x 0.396). The tax paid reduces the investor s estate by $396,000. If Tom is at the 40% estate tax bracket, there is a potential estate tax savings of up to $158,400 ($396,000 x 0.40). Key conversion consideration #3: How long will the investor hold the Roth assets? Generally, the shorter the timeframe the less appealing it is to convert because the investor will have less time to make up for what he or she paid in taxes on the conversion especially if he or she anticipates being in a lower tax bracket in retirement than at the time of the conversion. Another time-related concern is access to the converted assets without penalty. Investors must be aware that there is a five-year waiting period before they would be eligible to withdraw converted assets without a penalty. There are distinct distribution rules that apply to s vs. designated Roth accounts, but in either case, if an investor s withdrawal from a or designated Roth account contains conversion assets that were initially taxable upon conversion (pretax conversion assets), a 10% early withdrawal penalty may apply to the pretax conversion assets if they are taken within five years of their conversion (IRS Notice ). A penalty would not apply if the investor has an exception to the penalty under IRC Sec. 72(t), such as attainment of age 59½.

3 Key conversion consideration #4: What about required minimum distributions (RMDs)? Does the investor wish to avoid RMDs during his or her lifetime? The answer to this question will help the investor determine whether he or she should consider a over a designated Roth account within a workplace retirement plan, because each arrangement treats RMDs differently. RMDs are the minimum amounts that the IRS requires investors to withdraw each year from certain retirement savings arrangements, starting when the investor reaches his or her required beginning date (RBD). Owners of s are not required to take RMDs during their lifetimes, whereas owners of qualified Roth accounts in workplace retirement plans are. (Note: If eligible for a withdrawal of the qualified Roth account, the plan participant could roll over all non-rmd amounts to a in order to avoid future RMDs.) So, while the owner is alive, he or she never needs to distribute assets. This trait makes the a great tool for wealth accumulation for beneficiaries. Beneficiaries of a must take RMDs, but they are tax-free as long as the account has been held for five years by the account owner and beneficiary combined. Key conversion consideration #5: Can an investor undo a conversion? A recharacterization allows an investor to undo a conversion and eliminate the tax liability on converted assets by moving the assets back to an as long as it is done within the IRS prescribed timeframe. A recharacterization can allow an investor to erase a disproportionate tax bill that resulted from a drop in value of assets following a conversion. An investor who converts pretax assets must include their value in his or her taxable income for the year. If the converted assets subsequently drop in value, the investor is still liable for the tax bill on the original conversion amount. However, the IRS will allow an investor to undo or recharacterize an unwanted conversion without tax or penalty and then reconvert it after a prescribed waiting period. To accomplish a recharacterization, an investor must transfer the converted amount, along with any gains or losses, back to a traditional (even in the case of an employer plan-to- conversion). If the investor files his or her taxes on time for the year of the conversion, he or she can recharacterize an unwanted conversion without tax or penalty up to October 15 of the year following the conversion. The investor would need to properly amend his or her tax return if he or she had already filed. Following a recharacterization, the investor can reconvert the same amount after he or she satisfies the required waiting period. The required waiting period ends on the date that is 30 days after the recharacterization or January 1 of the year following the conversion, whichever is later. Consequently, if an investor converts and recharacterizes in the same year, he or she must wait until the following year to reconvert. Example 1: Conversion, recharacterization and reconversion October 2015 January 2016 February 2016 March 2016 Convert During down market, value drops Recharacterize Reconvert $100,000 $100,000 Tax liability remains on $100,000 Tax liability now on John converts $100,000 of traditional pretax dollars to a in October In January 2016, his market value falls to, meaning he is now liable to pay taxes on the $100,000 converted, even though he now only has in his Roth. In February 2016, John recharacterizes his from a Roth back into a traditional and is not liable to pay taxes on the converted amount. John waits the required time period (30 days after the recharacterization, in the case) and then reconverts his assets back to a. He now has a 2016 conversion (not a 2015 conversion), and the amount is, rather than $100,000. He will include the taxable amount of the conversion in income for 2016.

4 Key conversion consideration #6: Why would converting to separate s be advantageous? If an investor is considering a conversion to a, then it may make sense for him or her to consider segregating more volatile assets from less volatile ones and converting different asset classes to separate s. This strategy would allow the investor to concentrate potential losses in one or more s, which would be beneficial should a recharacterization be warranted. For recharacterization purposes, gains and losses are determined at the plan level. Therefore, should one or more of the assets decline in value, the investor can target particular assets held in particular s for recharacterization and account for the full loss thereon, without considering gains (if any) from the other s. Example Chris converts his $1 million traditional to a with investments A, B, C and D. Shortly after the conversion, the drops in value. Upon closer examination, Chris finds that investment A gained $25k, investment B lost $225k, investment C gained $25k and investment D experienced no change. For recharacterization purposes, gains and losses are based on the as a whole; he would not be able to pick a specific underlying investment (e.g., B) to recharacterize. Therefore, if Chris were to recharacterize the entire $825k, he would only be able to reflect an aggregate loss of $175k. In contrast, Clark converted his $1 million traditional to four separate s: one for each investment option A, B, C and D. Shortly after the conversion, Clark finds that the investment A gained $25k, investment B Roth lost $225k, the investment C gained $25k and the investment D Roth experienced no change. Clark could choose to recharacterize the investment B and account for the full loss of $225k. Segregate asset classes to maximize recharacterization $1m $1m Conclusion $825k Roth 1 Inv. A Roth 2 Inv. B Roth 3 Inv. C Roth 4 Inv. D Conversions represent a pathway to amassing material Roth assets, especially for HNW investors. But just because HNW investors may be eligible to convert and retirement plan assets to Roth assets doesn t mean they should do so automatically without first carefully considering some important issues. Key considerations include tax liability, estate planning, beneficiaries, distributions and recharacterizations. Because conversions for HNW investors typically involve high values, a great deal is at stake. For this reason, they should involve the individual s entire financial team tax, estate and financial advisors as part of a comprehensive financial planning approach.

5 Knowledge plus know-how to help build your business The Learning Center is dedicated to supporting advisors in their quest for success. We don t just arm you with thought-leading insights, innovative ideas and proven tools, we show you how to use these resources to attract new clients and serve current clients even better. For more information, please contact your Columbia Threadneedle Investments representative at Investment products offered through Columbia Management Investment Distributors, Inc., member FINRA. Advisory services provided by Columbia Management Investment Advisers, LLC. Collectively, the entities are known as Columbia Management. This material is for educational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Columbia Management does not provide tax or legal advice. Consumers should consult with their tax advisor or attorney regarding their specific situation. Material prepared by the Retirement Learning Center, LLC, a third-party industry consultant that is not affiliated with Columbia Management. Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed by Columbia Management. Columbia Threadneedle Investments (Columbia Threadneedle) is the global brand name of the Columbia and Threadneedle group of companies. Columbia Management Investment Distributors, Inc., 225 Franklin Street, Boston, MA Columbia Management Investment Advisers, LLC. All rights reserved. columbiathreadneedle.com/us FF CT-LC/ G (12/15) CTLC0TEM/