PayTaxesLater E-Newsletter ACCUMULATE WEALTH AND REDUCE TAXES

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1 ACCUMULATE WEALTH AND REDUCE TAXES August 2002 Uncertainty and volatility in the market create both problems and opportunities for IRA owners who desire to convert either a portion of, or their entire IRA, to a Roth IRA. We stand by our conviction that many IRA owners would benefit from a Roth IRA conversion assuming the income taxes on the conversion can be paid with funds outside of the IRA. By implementing the aggressive strategy outlined in this article, you may be able to hedge your bets to take the full advantage of a Roth IRA conversion while reducing the risk of a downturn in the market after making a Roth IRA conversion. This article addresses the important question, Which assets should the IRA owner convert? For more detailed discussions of the benefits of a Roth IRA conversion and answers to the questions of how much and when to make a Roth IRA conversion, I recommend the following articles: IRAs After the TRA 97 What Hath Congress Roth? and The Roth s Real Advantage. 1 The ability to unconvert or reverse a Roth IRA conversion provides the key to identifying which IRA assets you might opt to convert to a Roth and the key to saving taxes. Technically, the correct term is to recharacterize a Roth IRA back to a traditional IRA. 2 First we need to understand the regulations governing recharacterizations. Then we will provide several examples of situations that can take advantage of those regulations. Rules Governing Recharacterizations James Lange, CPA, Esq. James Lange Law Offices Pittsburgh, PA As of 1998, the IRS has permitted IRA owners to unconvert Roth IRAs. The deadline for unconverting a year 2002 conversion is the extended due date of your 2002 tax return, or October 15, 2003 assuming you can obtain two valid extensions. 3 Normally you file your tax return by April 15, However, if you file an automatic extension, you may extend the deadline to recharacterize to August 15, If you are able to obtain a second extension (which is not automatically granted), you will receive an additional extension to recharacterize until October 15, We caution taxpayers that using the strategy in this article may not be a sufficient reason for the IRS to grant the second extension. There is also a special rule that allows you to recharacterize a year 2001 Roth IRA conversion as long as you filed your return timely and you take corrective action within the six-month extended period. 4 To take corrective action means following the steps required to file the election to recharacterize the IRA. 5 In this case, the steps would include filing an amended return to reflect the transfer. 6 The transfer must occur before the extended due date of the tax return for the taxable year in which the original Roth conversion was made. 7 After the transfer back, the election 1

2 to recharacterize the conversion cannot be revoked. 8 There are also rules limiting the frequency of conversions, recharacterizations, and reconversions. You may not make a Roth conversion, unconvert it and reconvert the same IRA money in the same year. 9 Even if you straddle different calendar years, you must still wait 30 days before reconverting a Roth IRA that you had previously converted and unconverted. 10 Procedure Notify the Trustees (of both IRAs involved) on or before the transfer date that you want to unconvert a particular Roth IRA. The notification must contain the following information: the type and amount of the conversion to the Roth IRA to be recharacterized; the date on which the conversion was made and the tax year for which it was made; a direction to the trustee to transfer, in a trustee-to-trustee transfer, the amount of the conversion and any net income allocable to it to the trustee of the recipient IRA;and any additional information needed to make the transfer. 11 If both of your IRAs are maintained by the same trustee, simply redesignating the IRA will be treated as a trustee-to-trustee transfer. 12 You must also report the recharacterization on the tax return for the tax year in which you made the original Roth conversion. 13 2

3 Roth Paying IRA Conversions An for College (Qualified Aggressive Tuition Program) Strategy Profiting from the Rules How do we profit from these rules or, looking at it another way, is there a legal loophole that can save IRA owners money? Example 1: Roth IRA Conversion Made in the Year 2002 Assume that Joe has five separate IRAs of $100,000 each, invested evenly in five asset classes-large cap stocks, small cap stocks, bonds, international stocks and cash. Any conversions or unconversions will be made through separate accounts. Though there is uncertainty as to the optimal amount to convert and when, let s assume Joe would benefit from a $100,000 Roth conversion during Joe s options include: 1. Action: Make a $100,000 conversion now (mid-2002) of any one of the asset classes and hope for an increase in the value of the investment that he chooses to convert. Result: It is a crapshoot. If he converts $100,000 and the investment increases to $200,000 by October 15, 2002, he will have a $200,000 Roth IRA for the tax on $100,000 conversion. This is a great deal. If the investment declines, it is not a great deal. If he converts an investment that is valued at $100,000 and it drops to $50,000 by the following October, he will be stuck paying income tax on $100,000 and only having a $50,000 Roth IRA. If the investment goes down, Joe should recharacterize the Roth IRA to avoid the tax on a $100,000 conversion. If he unconverts his Roth, he will be in a position similar to where he would have been if he had never made the conversion. Assuming the traditional IRA would also have declined in value had it been left alone, Joe will have a $50,000 IRA (and his experimental foray into the Roth environment will have had no tax consequences). Although it is discouraging that the investment went down, it isn t as bad as if he had had to pay income tax on a $100,000 conversion. The only way this strategy is a winner is if Joe picks the right asset class to convert. 2. Action: Make a $100,000 conversion now (mid-2002) consisting of one-fifth of each of the five asset funds and hope for an increase in the value of the investments. Result: This strategy is an attempt to hedge. This strategy will produce no windfall from investment returns, but will be a safer bet by using diversification to spread the money around. Joe may still unconvert the funds that break even or lose money, although this will reduce the total conversion amount and possibly not fulfill Joe s original objectives. 3. Action: Don t make any Roth IRA conversions. Result: A do-nothing strategy misses any opportunity to enjoy the tax-free growth offered by Roth IRA conversions. Perhaps it would be advantageous to consider a Roth IRA conversion in the future. 4. Action: Thread the loophole. Convert all five traditional IRAs to Roth IRAs and be primed to unconvert the investments that do the worst from the time of conversion to August 15, 2003 and if a valid second extension is accepted, until October 15,

4 Result: With perfect hindsight, Joe unconverts $400,000 of the original investments that did not perform as well as the $100,000 that Joe can choose to retain as a Roth IRA. Lucky Joe could reap an enormous windfall of tax-free growth in any one of the asset classes. He will still have to pay income tax on the $100,000 income for tax year 2002 (for the asset class he chooses to retain as a Roth). However, the value of the Roth will have increased. Then, possibly within the same family of funds so there are no transaction fees, he rebalances both his traditional IRA portfolio and his Roth IRA portfolio. The result is that he now has a larger and well-diversified Roth IRA. If the portfolio is comprised of individual securities, the same principle would apply. You could retain as Roth IRAs the securities that did well and recharacterize the ones that did not. However, we recommend that securities not be traded after conversion so they may be properly identified for purposes of unconversion, should it become necessary. If the future works out differently, Joe would respond differently. If all the asset classes went down, Joe could consider recharacterizing all of them in 2003 and then consider a future conversion based on lower values. Of course, most clients will feel uncomfortable with the thread the loophole approach. It may seem like too much of a gamble. There could be follow through failures. The IRA owner might forget to unconvert and that could present a financial disaster. Or the IRA owner might die. (Though Roth IRAs are perhaps even more favorable for estates than traditional IRAs because the executor, administrator, or other person responsible for filing the final tax return for the decedent may unconvert on behalf of the decedent.) 14 What follows is a potential timeline for the conversion and recharacterization process. Time Line 2002 Make a conversion before year-end. Please note that many brokerage houses need at least a week and sometimes longer to process the paperwork. Therefore, I would consider the practical deadline to be about December 15, 2002 to make the conversion April 15 File first extension for your 2002 tax return if you want more time to decide on your year 2002 conversion. As noted above, you can file your return if you are ready and still take advantage of the six-month additional period to make the recharacterization, but you must be prepared to affect the transfer and file an amended return by October 15. August 15 Deadline to unconvert undesirable 2002 conversions and file by the close of the automatic extension period. (Filing a second extension is possible, with a valid reason and approval from the IRS. It is not automatic. We would not recommend that you request a second extension for reasons related to waiting to see how your converted Roth IRA in- 4

5 vestment performs, since this will probably not be viewed as a valid reason by the IRS.) September 15 First opportunity to reconvert the recharacterized traditional IRA. (Could be earlier if the recharacterization was done earlier than the deadline.) October 15 Final deadline to unconvert undesirable 2002 conversions with a valid second extension or by means of an amended return. November 16 First opportunity to reconvert the recharacterized traditional IRA. (Could be earlier if the recharacterization was done earlier than the deadline.) December 31 Last chance for additional Roth conversions for This timeline does not project beyond 2003, but barring other tax law changes, the same logic would continue to apply for future years. Conclusion The most important piece of advice in this article is: when in doubt, make the conversion. You can always recharacterize or partially recharacterize later if the conversion proves counterproductive. But if you win with the Roth conversion, the long-term benefits of owning a Roth IRA are superior to the traditional IRA. Most clients will not have the interest or the time to engage in some of the more complicated strategies suggested in this article. But, for clients or planners who do take the time to properly implement the suggested strategy, the potential for rewards is great. Footnotes 1. James Lange, IRAs After TRA 97 What Hath Congress Roth? The Tax Adviser, May 1998, at 318; James Lange and Steven T. Kohman, The Roth s Real Advantage, Financial Planning, May 2000, at Code Sec. 408A(d)(6); Reg A Code Sec. 408A(d)(7). 4. Reg (b). 5. Reg (c). 6. See Instructions to IRS Form Reg A-5, Q&A -6(b). 8. Id. 9. Reg A-5, Q&A -9 (a). 10. Id. 11. Reg A-5, Q&A-6(a). 12. Reg A-5, Q&A-1(a). 13. Reg A-5, Q&A-6(b). 14. Reg A-5, Q&A-6(c). Reprinted with Permission from the Journal of Retirement Planning. PayTaxesLater Newsletter Law Offices of James Lange 2200 Murray Avenue Pittsburgh, PA FAX admin@paytaxeslater.com 5