Roth IRAs and the Opportunity Ahead February 2010

Transcription

1 Roth IRAs and the Opportunity Ahead February 2010 Beginning in 2010, everyone will be eligible to participate in a Roth IRA. While the income limits for making contributions will remain in place, the $100,000 modified adjusted income cap for converting a Traditional IRA to a Roth IRA will be lifted. This cap was suspended in 2006 through the enactment of the Tax Increase Prevention and Reconciliation Act of The Roth conversion has created a compelling opportunity to grow retirement assets tax-free, as opposed to tax-deferred, which is what nearly all existing retirement and qualified plans (non-roth IRAs, 401k and 403b plans, and many others) have been designed to allow. The two methods of funding a Roth IRA are: 1) making non-deductible contributions of after-tax funds, or 2) converting an existing IRA or tax-deferred retirement plan to a Roth IRA. There are income limits for making contributions to a Roth IRA; the modified adjusted gross income limits (MAGI) for 2009 are $105,000 for individual tax filers and $166,000 for joint filers. (Individuals with MAGI s of up to $120,000 can make partial contributions; the contribution limit phases out as the MAGI increases. This also applies to joint filers where the limit is $176,000.) The limits for the Roth conversion, as mentioned previously, will no longer be in effect after this year. The Roth conversion most commonly involves the Traditional, SIMPLE or SEP IRA, but, recently many employer sponsored retirement plans have adopted provisions to allow direct conversions to a Roth IRA. (In the past, assets in the plan had to first be rolled over into a Traditional IRA.) Converting a Traditional IRA to a Roth IRA entails including the value of assets to be converted (partial conversions are allowed) in ordinary income on one s tax return and paying the resulting tax. (Only deductible contributions to Traditional IRAs and accrued income on non-deductible IRAs need to be included.) The cost of converting can be prohibitively expensive, especially for individuals with large retirement account balances (this expense is addressed further below). The conversion income typically has to be recognized in the year that the conversion is performed, but for conversions performed in 2010 there is a choice of recognizing the income in its entirety in 2010, or in equal amounts in 2011 and 2012; the latter option is the default. The Roth IRA s features make it an attractive vehicle for potentially growing after-tax wealth and worth considering despite the potentially large tax outlay. Over the course of this memo, we will review these features and benefits, and more importantly, discuss the upcoming opportunity to perform the Roth conversion - its implications, caveats, risks and ways to offset them. Before we begin, it is probably worth stating that, all things being equal; asset growth in a Roth IRA will be maximized when the assets are left intact to grow so the benefit from HILLVIEW CAPITAL ADVISORS, LLC 369 Lexington Avenue, 25th Floor, New York, NY T F NEW YORK PHILADELPHIA

2 compounding will increase as withdrawals decrease and vice versa. In keeping with this logic, the taxes resulting from a Roth conversion would best be paid from non-roth sources. TAX FREE GROWTH The primary benefit of the Roth IRA is that growth and income generated in the account is tax-free. The growth and income in the vast majority of non-roth retirement accounts is only tax-deferred. The account holder only keeps a portion of those funds as both the principal and the growth are taxable upon withdrawal. On the other hand, since Roth IRAs are funded with after-tax dollars, future growth is tax-free and 100% of the funds are available to the account holder. NO REQUIRED MINIMUM DISTRIBUTIONS There are no minimum distribution requirements for Roth IRAs as there are for Traditional IRAs. Currently, holders of tax-deferred retirement vehicles are required by law to take minimum distributions (based on IRS schedules) after age 70½, or face a penalty. For those that don t want or need to take distributions from retirement assets for lifestyle funding, minimum distributions have a financial cost (taxes) and opportunity cost (less taxfavored investable assets). The absence of distribution requirements for the Roth IRA allows assets to grow untouched. This is a distinct advantage it has over the Traditional IRA in cases where there is no need to take distributions. TRANSFERS AT DEATH At the account owner s death, the assets will be transferred to a designated beneficiary. Excluding non-persons like charities or Trusts, there are two types of beneficiaries: spousal and non-spousal, for both Traditional and Roth IRAs: Spousal beneficiaries can treat the IRA account as if it were their own; Non-spousal beneficiaries are required to take minimum distributions (based on IRS rules) annually starting the year after the account holder s death. The difference between the two IRAs is that the spousal beneficiary of the Traditional IRA will be subject to minimum distributions rules. As stated in the previous section, this is not ideal for asset growth. These distributions can result in significant lost leverage by the time the assets are transferred to a non-spousal beneficiary. The non-spousal beneficiary will also be subject to minimum distributions based on their life expectancies. If the beneficiaries of both types of IRAs only take the minimum distributions, the bulk of the assets will still be working for them. In this instance it will again be more advantageous to have assets grow tax-free in the Roth IRA than taxdeferred in the Traditional IRA. This advantage is magnified in proportion to the length of the time horizon (life expectancy). Roth IRAs and the Opportunity Ahead February 2010 Page 2

3 OTHER CONSIDERATIONS ESTATE IMPLICATIONS The payment of the conversion tax will reduce the size of the account holder s estate and potentially lower the estate tax liability. It is also worth noting that bequests of Roth IRA assets are more tax efficient than tax-deferred assets since future withdrawals can be made tax-free. UTILIZING INCOME OFFSETS A taxpayer can use the income that must be recognized upon converting to absorb net operating losses, charitable deduction carry-forwards and excess itemized deductions, potentially lowering the conversion tax. RISKS, RECHARACTERIZATIONS, RECONVERSIONS The risk associated with performing the Roth conversion is that the IRA will decline substantially in value pursuant to the conversion causing a portion of taxes paid to have been on lost value. A re-characterization provides individuals with an opportunity to reverse the Roth IRA conversion by the tax filing deadline for the year in which the conversion was performed. The Roth IRA assets are then considered to have been transferred to a new Traditional IRA. To provide an example: someone who converts their Traditional IRA on January 4 th 2010 would have up until October 17 th 2011 to re-characterize their Roth IRA. They would have nearly 2 years to evaluate the performance of the assets held in the Roth IRA and determine whether the conversion tax was money well spent or a re-characterization should be performed. Assets that have been re-characterized to a new Traditional IRA can be converted to a Roth IRA. This is known as a reconversion and can only be done after 30 days from the date of re-characterization or on January 1st of the tax year following the year of the conversion, whichever is later. Only one conversion can be done per year. Someone can choose to re-characterize a Roth conversion if the market value of the account has declined substantially, and then re-convert the new Traditional IRA balance to a Roth IRA and potentially pay taxes on a lower balance of assets. For example: Jim, who is in the 35% income tax bracket, converts his $1 million Traditional IRA to a Roth IRA on January 4 th, 2010 owing in the process $350,000 in taxes which is paid from a taxable account. The market value of his Roth IRA subsequently declines so that by the end of October 2010, the market value of the assets is $600,000. He re-characterizes his Roth IRA on November 1 st, 2010 and the assets are transferred to a new Traditional IRA. He can reconvert this Traditional IRA on January 1 st 2011 and pay a lower tax than he did on the first conversion if the value of the account is less than $1 million at the time and tax rates remain the same. The advantages of being able to re-characterize and reconvert an IRA are that it provides protection in the form of tax savings if assets decrease substantially in value (re- Roth IRAs and the Opportunity Ahead February 2010 Page 3

4 characterization), and, if the value remains depressed, that the taxes will be lower upon reconverting. MITIGATING FACTORS HISTORICAL ASSET PERFORMANCE, TIME The benefits of the Roth IRA and the conversion only materialize in an environment where asset values increase. Re-characterizations, though not specifically designed to protect against depreciating values, certainly provide a measure of protection against overpaying taxes should the market value of assets decline and not against market risk. The risk of falling market values is very real as our recent experiences have reminded us. However, given long enough investment horizons, asset values have historically increased on average in nominal and real terms. While it bears repeating the oft-used disclaimer past performance is not indicative of future results, we believe that asset values will continue to rise, especially over the long run, even though the opportunity set in the near term has narrowed as the global economy continues to recover from the damage caused by the financial crisis. This tendency for returns to revert to the mean (average) has positive implications for considering a Roth conversion, making it an attractive vehicle for accumulating and growing wealth. However, we believe any investment program instituted within the Roth IRA should consist of an appropriately diversified asset allocation mix. In summary, we view the Roth IRA as an attractive structure for accumulating and growing after-tax wealth, and as superior to the Traditional IRA or other tax-deferred retirement structures due to the tax-free growth that is achievable in the account and the absence of distribution requirements. In many cases, these two attributes of the Roth IRA present sufficient reason for performing the conversion however; we think the argument for performing the conversion becomes much more compelling when there is a low dependence on the funds for consumption needs (see chart below). In these instances, the Roth IRA is a highly effective and tax efficient means for transferring income tax- free wealth. 100% - Roth Conversion: Decision Dynamics LESS FAVORABLE RELIANCE ON FUNDS LESS FAVORABLE MORE FAVORABLE TAX BRACKET 0% MORE FAVORABLE TIME TO RETIREMENT + Roth IRAs and the Opportunity Ahead February 2010 Page 4

5 The case for or against converting is rarely clear cut so it is vital to evaluate each situation on its own merits. It is also essential for your tax and investment advisors to share information in order to determine the suitability of the Roth conversion, and to properly implement and monitor its progress. We are well equipped in this regard with the knowledge and tools to analyze the Roth conversion s costs and benefits. We welcome the opportunity to speak to you or your tax advisor regarding the Roth conversion and would be happy to help you determine whether it is appropriate for your situation. Regards, William S. Choi, CFA VP, Director of Financial Planning IRS CIRCULAR DISCLOSURE NOTICE: IRS Circular 230 regulates written communications about federal tax matters between tax advisors and their clients. To the extent the preceding correspondence and/or any attachment is a written tax advice communication, it is not a full covered opinion. Accordingly, this advice is not intended and cannot be used for the purpose of avoiding penalties that may be imposed by the IRS regarding the transaction or matters discussed herein. Roth IRAs and the Opportunity Ahead February 2010 Page 5