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25 Tax planning considerations for 2012 Executive summary As political power shifts in Washington, our national tax policy seems to shift as well. At times throughout the past few years, the future direction of tax changes seemed uncertain as the 2001 tax laws are set to expire at the end of 2012, and debate in Congress on the further extension of these laws continues without resolution. The expiration of the 2001 laws will increase income taxes to pre-2001 levels, raise capital gains rates, tax dividend income at ordinary income rates, and return the estate tax exclusion amount to $1 million per individual. While it s impossible to predict what Congress may further change this year or in 2013 and beyond, now may be a good time to take a proactive look, with your TIAA-CREF Advisor, at your tax planning, estate planning and gift giving strategies. In this article, TIAA-CREF s wealth planners Doug Rothermich and John O Shea outline a series of considerations for your review, focusing on: Income and capital gains tax planning pg 2 With federal income tax rates at their lowest point in 60 years, what income and capital gains tax strategies should you consider? A clear understanding of your current tax bracket, personal cash flow and investment time horizon can help you decide the best approach to take. Estate tax planning pg 4 A new portability feature enables you to pass your unused estate tax exclusion to a surviving spouse, but do the benefits outweigh any disadvantages? Thinking through your family, tax and estate planning situations will help you in your decision. Gift tax planning pg 9 Changes in federal gift tax laws may offer new wealth transfer opportunities for your family. A review of these changes is provided for your consideration.

26 Tax planning considerations for 2012 Income and capital gains tax planning Short-term tax strategies to consider Through 2012, federal income tax rates will be as low as at any time during the past 60 years. The Bush Tax Cuts from the 2001 Tax Act brought the tax brackets set forth in the table on page 3. Those changes also phased in a series of tax benefits all of which finally became effective in The 2010 tax law changes extend these benefits through Under these rules, you can: Continue to receive a dollar-for-dollar deduction for allowable itemized deductions as the traditional phaseout rules are suspended for Use your full personal exemption amount of $3,650 if single, and $7,300 if married filing jointly. And, if you fall in the 10% or 15% income tax bracket, you will pay no tax on dividends or long-term capital gains. If your federal income tax bracket is 25% or higher, you will pay tax on dividends and long-term capital gains at a 15% flat tax rate. If Congress fails to act, and the 2001 tax provisions expire by their own terms at the end of 2012, your federal income tax rates could substantially increase in 2013 to the rates set forth in the table on page 3. Under current law, as this occurs, dividends will become taxable at ordinary income tax rates rather than at long-term capital gains rates. The traditional phaseout of itemized deductions and personal exemptions would also be reinstated. 1 If you fall in the 15% tax bracket, you will pay tax on long-term capital gains at either an 8% or 10% tax rate, depending upon how long you owned the asset; and, if your federal income tax bracket is 25% or higher, you will pay long-term capital gains tax at either 18% or 20%, again depending on how long you owned the asset. Aside from possible income tax changes, in 2013 the healthcare law passed in the spring of 2010 provides that two additional Medicare taxes will take effect. The first provides a 0.90% tax on earned income in excess of $200,000 (for a single taxpayer) or $250,000 (for married taxpayers filing jointly). The second additional tax is a 3.8% tax on the lesser of your net investment income 2 for the tax year or your modified adjusted gross income in excess of $200,000 (if single) or $250,000 (if married), or in excess of $125,000 (if married filing separately). The combination in 2013 of these two tax changes (i.e., the scheduled repeal of the 2001 tax laws and the imposition of the new healthcare taxes) could result in significant changes. The tax on dividends could increase from 15% today (for those in the top bracket) to 43.4%. Capital gains taxes could increase from 15% to 23.8%, and the amount of ordinary income subject to tax could increase as rates go up and deductions become more limited. Given the dramatic impact these tax changes could have, now is a good time for you to work with your financial advisor to develop a better understanding of current tax policy, your personal cash flow, your investment horizon, and your current tax bracket. Armed with this information, you will be positioned to make tax-wise decisions. 1 If 2001 tax cuts are allowed to sunset in 2013, itemized deductions (excluding medical expenses, investment interest, theft and casualty losses, and gambling losses) will be reduced by 3% of the amount by which Adjusted Gross Income (AGI) exceeds a statutory floor (i.e., $167,000 if married filing jointly and $83,550 if married filing separately) but not by more than 80% of the allowable deductions. 2 The term net investment income includes interest, dividends, long-term capital gains, distributions from after-tax annuities, royalty income, and rental income. 2

27 Tax planning considerations for 2012 For example, you might decide to accelerate additional income into 2012 to fully use your lower tax brackets (e.g., accelerating a year-end bonus, making partial Roth conversions, taking a distribution from a nonqualified deferred compensation plan, accelerating accrued interest on U.S. savings bonds, or withdrawing assets from an after-tax annuity product). Likewise, if you have unrealized long-term capital gains, you might consider with your investment advisor if realizing a portion or all of the unrealized gain may make sense prior to such law changes. This strategy could make sense if you re planning to liquidate an appreciated asset in the near term (e.g., within the next five or six years or so). If you plan to own the asset for longer, this strategy makes less sense as the loss of cash associated with the tax payments may outweigh the longer-term tax savings. Discuss these issues with your tax and investment advisors, and watch closely how the political landscape may develop as 2013 approaches. Federal income tax rates in transition 2012 federal tax rates 10% (s) $0 - $8,700 (m) $0 - $17,400 15% (s) $8,701 - $35,350 (m) $17,401 - $70,700 25% (s) $35,351 - $85,650 (m) $70,701 - $142,700 28% (s) $85,651 - $178,650 (m) $142,701 - $217,450 33% (s) $178,651 - $388,350 (m) $217,451 - $388,350 35% (s) >$388,350 (m) >$388, federal tax rates (estimated assuming sunset of 2001 tax cuts) 10% None 15% (s) $0 - $35,020 (m) $0 - $70,040 28% (s) $35,020 - $84,872 (m) $70,040 - $141,419 31% (s) $84,872 - $177,006 (m) $141,419 - $215,528 36% (s) $177,006 - $384,860 (m) $215,528 - $384, % (s) >$384,860 (m) >$384,860 3

28 Tax planning considerations for 2012 Estate tax planning Historical view of exclusion amounts for the federal gift tax and estate tax Year Federal gift tax exclusion Federal estate tax exclusion $30,000 $60, $120,667 $120, $225,000 $225, $275,000 $275, $325,000 $325, $400,000 $400, $500,000 $500, $600,000 $600, $625,000 $625, $650,000 $650, $675,000 $675, $1,000,000 $1,000, $1,000,000 $1,500, $1,000,000 $2,000, $1,000,000 $3,500, $1,000,000 Repealed 2011 $5,000,000 $5,000, $5,120,000 $5,120, and $1,000,000 $1,000,000 beyond 3 3 As per current law The impact of portability on your estate planning As you consider short-term income and capital gains tax opportunities, don t overlook the impact of recent changes on your estate planning, in particular the creation of a portability feature of estate tax exclusions for couples. As a result of the 2010 tax law changes, for the first time portability of the federal estate tax exclusion amount between spouses is now available. Portability simply means if a spouse dies and has not fully used his or her federal estate tax exclusion amount, the unused portion rolls over to the surviving spouse. The ability to port or carry over the unused estate tax exclusion amount of a deceased spouse to the surviving spouse is a potentially significant development, and may be reason to discuss with your attorney whether it s a good time to review and update your existing estate planning documents. As you consider the use of portability, be cautious of its current short-term use. Portability is scheduled to expire after Appropriate changes in your situation will depend on your personal circumstances and strategies that make the most tax sense for you. How exclusions worked before portability For decades, the federal transfer tax system provided every individual with a lifetime gift tax exclusion and an estate tax exclusion amount albeit at varying levels over time (see the chart at left). Any gift tax exclusion amount used during your lifetime typically reduced the estate tax exclusion amount available at your death dollar-fordollar. For example, if during your lifetime you used $500,000 of your lifetime gift tax exclusion amount to shelter taxable gifts, at your death your estate tax exclusion amount would be reduced by this $500,000 amount. Over the past decade, allowed levels of the gift and estate tax exclusion amounts have varied. When enacted, the 2001 tax law provided the estate tax (but not the gift tax) would be repealed in 2010 but only for that year. Prior to 2010, the estate tax exclusion amount had increased from $675,000 in 2001 to $3.5 million for During this period, the gift tax exclusion went to $1 million but stayed at that level. According to the 2001 law, the estate tax exclusion was to return to $1 million for the 2011 tax year. While many commentators thought Congress would simply return the 2011 estate tax to 2009 levels (returning the estate tax exclusion to $3.5 million and leaving the gift tax exclusion at $1 million), the 2010 tax law increased both the gift and estate tax exclusion amounts to $5.12 million for 2012 (and reduced the tax rate to 35% from 45-55%) exemplifying the policy swings by Congress, and leaving wealthy families scratching their heads about where the estate tax system would go in the future. This increase in the gift tax exclusion also creates significant gift planning opportunities discussed on page 9. Historically, for married couples who wanted to fully use both spouses exclusion amounts, this system required careful planning to ensure, regardless of the order of their deaths, the full estate tax exclusion amount could be used at the first of their deaths. This form of planning typically required that a trust (often called a credit shelter trust) be established within each spouse s estate planning documents so that at the first spouse s death, it could be funded with the deceased spouse s estate tax exclusion amount. Doing so ensured the deceased spouse s exclusion would be used, and when the surviving spouse s death subsequently occurred, his or her exclusion amount was then available to shelter additional assets in his or her estate from estate tax. Consider the example on page 5. 4

29 Tax planning considerations for 2012 Implementing a credit shelter trust Assume Arthur and Emily have a combined estate valued at $7 million when Arthur dies in Using conventional planning, if Arthur funded a credit shelter trust at his death with his $3.5 million estate tax exclusion amount, and left all other assets to Emily (subject to the unlimited estate tax marital deduction), no tax would be due at Arthur s death and the full amount funding the credit shelter trust would be excluded from Emily s estate for estate tax purposes. The credit shelter trust could be drafted to designate Emily as a beneficiary of the trust during her remaining lifetime, but the trust would be structured to keep the trust assets out of her estate for tax purposes. When Emily subsequently dies, her exclusion amount would be available to shelter the assets in her estate (up to her exclusion amount). In this example, proper planning and appropriate titling of their assets could have protected their full $7 million from federal estate tax. By contrast, if at Arthur s death all of the couple s assets were transferred to Emily (so the full $7 million was includible in her estate for estate tax purposes), then at her death, Emily s $3.5 million exclusion amount (using 2009 amounts) would shelter half of these assets from tax, but half of their assets would have been subject to estate tax. While it may have been a simple plan to leave everything directly to Emily, it effectively would have wasted Arthur s estate tax exclusion amount and increased the estate tax on Emily s estate by approximately $1.5 million. For those who have significant IRA or retirement plan assets, arranging their planning in a manner to capture this form of trust and estate tax planning often became difficult when the assets were payable to the surviving spouse as the primary beneficiary. How portability makes estate planning simpler The portability concept built into the 2010 tax law allows the unused estate tax exclusion amount of the first spouse to die to roll over to the surviving spouse helping alleviate any wasted exclusion amount and creating greater flexibility for married couples in their estate planning. With portability of a deceased spouse s unused estate tax exclusion amount, and an increase in both spouses exclusion from $3.5 million in 2009 to $5.12 million for 2012, Arthur s unused federal estate tax exclusion amount could roll over to Emily, and add to the amount she could individually shelter from tax effectively allowing a husband and wife to ensure the full amount of their respective exclusion amounts are used even if their planning doesn t do so neatly through asset titling and trust planning on the first spouse s death. Issues to consider before using portability While portability in some situations can simplify your estate planning, there are also several compelling reasons to still consider funding the deceased spouse s exclusion amount by establishing a credit shelter trust upon the first spouse s death. These reasons include: 5

30 Tax planning considerations for 2012 Estate tax law volatility. What Congress has given, Congress may take away (and is currently scheduled to do so after 2012). Relying on large exclusion amounts and portability raises the question of whether both will be in effect at your death or your spouse s death. Over the course of the past 10 years, the estate tax exclusion amount has increased substantially (from $675,000 to $5.12 million per estate), and as it has done so, many in Congress have become more vocal that the tax code has gone too far. With our ever growing federal debt levels, Congress could lower the federal estate tax exclusion amount (or allow that to occur in 2013 by doing nothing to extend current levels). If that occurs, having a fully funded credit shelter trust in place from the first spouse s death would permanently exclude the trust assets from inclusion in the survivor s estate. As credit shelter trusts can be drafted in a manner to give the surviving spouse great latitude and access to trust income and principal, for larger estates (e.g., arguably, those above $3-5 million), there is considerable merit in continuing to use a credit shelter trust at the first spouse s death to ensure those assets are always sheltered from estate tax even if the exclusion amount is reduced in years following the first spouse s death. Key point on life insurance coverage. With all of the uncertainty on the direction of the estate tax exclusion, avoid reducing any life insurance coverage. If you later decide you need the coverage, changes in your age or health could make reacquiring coverage costly or impossible. Credit shelter trust gains are excluded from the survivor s estate. If the size of your estate exceeds or could exceed the amount of both spouses estate tax exclusion amounts by the time of the surviving spouse s death, using a credit shelter trust at the first spouse s death will continue to have merit (even with portability). Remember, all assets in a credit shelter trust are excluded from the survivor s estate for tax purposes including any gain on the assets from the time of the first spouse s death until the survivor s death. If you are married and the size of your estate may cause the survivor to incur a federal estate tax, fully funding a credit shelter trust at the first spouse s death will also exclude all appreciation on the assets during the survivor s remaining lifetime from estate tax. Remarriage. In some instances, relying on portability to ensure both spouses estate tax exclusion amounts are used is also risky if the surviving spouse may later decide to remarry. If a surviving spouse is predeceased by more than one spouse, the amount of unused exclusion available for use by the surviving spouse is limited to the lesser of $5.12 million for 2012 or the unused exclusion of the last such deceased spouse. Such restrictions make the application of portability unpredictable in many situations. Accordingly, as with the likelihood of further volatility in future tax changes, using a traditional credit shelter trust as a means to lock in the use of the first spouse s estate tax exclusion amount will continue to seem prudent in many situations. Multigeneration trust planning. In many families, multigeneration trust planning that provides for the benefit during a child s life, and then continues beyond the child s death for the benefit of grandchildren, can provide numerous benefits. When your generation-skipping transfer tax exemption is applied to such a trust (an exemption equal to your estate tax exclusion amount), your assets may continue in trust for multiple generations without being subject to estate tax at the death of each generation. Likewise, trust planning can allow you the ability to control when and how assets are used by your beneficiaries, and protect trust assets from a descendant s creditors or a divorcing spouse. If multigeneration trust planning is appropriate in your family s situation (for tax or other planning reasons), keep in mind that portability does not currently apply to a deceased spouse s unused generation-skipping transfer tax exemption. 6

31 Tax planning considerations for 2012 State estate tax planning. In many instances, portability may seem adequate to provide for the estate tax protection you seek for your assets. However, keep in mind portability at this time only applies at the federal level. If you currently live in a state with its own state-level estate tax system (see State Tax Table on page 8), the use of credit shelter trust planning within your estate planning documents will continue to make sense to shelter assets from the state estate tax. In this situation, funding a credit shelter trust with (at least) the state estate tax exclusion amount may be wise even where portability could suffice to shelter assets from estate tax at the federal level. However, the use of credit shelter trust planning during 2012 could depend on your state s gift and estate tax rules. While credit shelter trust planning may in many instances make sense to shelter the full federal estate tax exclusion amount at the first spouse s death, some state-specific circumstances may merit careful review with your attorney. For example, if your state has a state-level estate tax, but does not impose a state-level gift tax, it may be wise to transfer to your surviving spouse any amounts above the state-level estate tax exemption at your death. Your surviving spouse can then use your portable exclusion (or the amount of your unused exclusion) to make lifetime gifts to your loved ones (or a trust for their benefit) free of state and federal gift tax, and the gifted assets could then escape state (and federal) estate tax at the time of the surviving spouse s death. At this early point in the development of portability, it s not entirely clear how a surviving spouse will use portable exclusion amounts for lifetime gift tax purposes. You should consult your attorney to think through how to best navigate such planning in your state to capture effective state and federal gift and estate tax planning. Consider if disclaimer planning may be helpful. If, under the current higher exclusion amounts and with portability, you prefer the simplicity of avoiding complex credit shelter trust planning, but you are hesitant about how this may change in the future, consider with your attorney if using a disclaimer plan may be a viable solution in your situation. A disclaimer is a tool a beneficiary can use to decline to receive inherited assets. When properly executed, the disclaiming individual is treated as not surviving you for tax purposes. Contemplating the possible use of a disclaimer by a surviving spouse can create planning flexibility. A disclaimer plan might provide that all of your assets would transfer to your surviving spouse; provided, however, if your spouse disclaims any of those assets, the disclaimed assets would (by the terms of your estate planning documents and/or beneficiary designations) automatically fund a credit shelter trust. For example, assume Arthur leaves all of his assets to his wife, Emily; provided, however, if Emily disclaims any of such assets, the disclaimed assets would then fund a credit shelter trust for her benefit. Following Arthur s death, Emily can then decide (post-mortem) if she will simply accept all of the assets or disclaim some portion (or all) of the assets to have them fund the credit shelter trust. In some situations, this form of planning is particularly attractive during these times when so much uncertainty surrounds the idea of whether it may ultimately make sense to rely on portability and current tax laws for your planning. This approach allows a married couple to include some simple outright bequests to the surviving spouse, but still take a wait-and-see approach if more complex planning may make sense as your assets grow, as the tax laws change further, or as your family dynamics change or evolve over time. 7

32 Tax planning considerations for 2012 State tax table 4 State Estate/ inheritance tax Exemption Gift tax Connecticut Estate $2 Million Yes Delaware Estate $5.12 Million No D.C. Estate $1 Million No Hawaii Estate $3.5 Million No Illinois Estate $3.5 Million No Indiana Inheritance 5 No Iowa Inheritance 5 No Kentucky Inheritance 5 No Maine Estate $1 Million No Maryland Both $1 Million No Massachusetts Estate $1 Million No Minnesota Estate $1 Million No New Jersey Both $675,000 5 No New York Estate $1 Million No North Carolina Estate $5.12 Million No Ohio Estate $383,333 No Oregon Estate $1 Million No Pennsylvania Inheritance 5 No Rhode Island Estate $892,865 No Tennessee Inheritance $1 Million Yes Vermont Estate $2.75 Million No Washington Estate $2 Million No 4 States not listed currently impose no state-level estate or inheritance tax. 5 Exemption to these state inheritance laws vary based on different classes of beneficiaries. 8

33 Tax planning considerations for 2012 Gift tax planning An increase in the gift tax exclusion amounts create new gifting opportunities For wealthy individuals (single or married), possibly the most exciting planning development from the 2010 tax law changes is the increase in the federal gift tax exclusion from $1 million to $5.12 million. This increase creates a significant number of creative planning opportunities for tax-free wealth transfers to your loved ones. As you think through the issues and impacts of tax law changes, consider gifting strategies and other estate planning opportunities presented from the gift tax exclusion increase. Wealth transfer taxes have been a part of our tax system since Over the years, the form of tax has often varied. The last major re-write of the federal wealth transfer tax system occurred as part of the Tax Reform Act of 1976 when the system was segmented into three related components: a gift tax, an estate tax, and a generationskipping transfer tax. Some suggest that in addition to their role in producing federal tax revenue, these three components protect the federal income tax system by discouraging taxpayers from making lifetime transfers to shift the income tax burden to lower-bracketed loved ones. For 2012, however, the significant increase in the federal gift tax exclusion (and generation-skipping transfer tax exclusion) provides you with an opportunity to move assets that produce taxable income from you to lower-bracketed loved ones and to allow all post-gift appreciation to completely escape gift and estate tax. Basic gift tax rules provide you can make a present interest gift of up to $13,000 per year to as many individuals as you prefer (the annual gift tax exclusion amount ). The IRS does not require any formal reporting for such annual gifts. In addition to these annual gift exclusions, you may also make unlimited gifts for tuition, healthcare, or medical insurance, provided such gifts are made directly to the provider (i.e., the payment is made directly to the school registrar, doctor, hospital or insurance company). Gifts above your annual gift tax exclusion amounts or indirect gifts for tuition or medical expenses are considered taxable gifts. If such taxable gifts are within your lifetime federal gift tax exclusion amount (now increased to $5.12 million for 2012), you are required to report these gifts on a federal gift tax return (Form 709), but no federal gift tax is owed until lifetime gifts, in their aggregate, exceed the exclusion amount of $5.12 million (for a single individual) or $10.24 million (for a married couple). Gifts in excess of the exclusion amounts are now taxed at a flat 35% rate. Applying gift tax exclusion to income-producing property To illustrate how the increased federal gift tax exclusion amount may be used for effective tax planning, and to provide potential intra-family income tax benefits, consider the following example. William is single and owns an apartment building having a fair market value of $700,000 that produces $40,000 of net rental income annually. William is in the 35% federal income tax bracket, and pays about $14,000 in federal income tax on the net rental income. In 2013, if income tax rates return to pre-2001 levels and when last year s healthcare law will impose a new Medicare tax on unearned income, William could be in a 43.4% bracket (39.6% income tax bracket, plus a 3.8% Medicare tax on net investment income), causing the federal tax on his rental income to increase to $17,360 an increase of $3,360 of tax each year (a 24% tax increase from current levels). 9

34 Tax planning considerations for 2012 William can opt to transfer the apartment building into a limited liability company (LLC) or similar entity, and to split the ownership interest within that entity into voting and non-voting interests. Assume William creates an LLC with a 10% voting interest and a 90% non-voting interest, and that he retains the voting interest (for control reasons) and makes a gift of the 90% non-voting interest in equal proportions to his three adult children using a portion of his lifetime gift tax exclusion amount. If William s children are all in the 28% federal income tax bracket, they would pay a combined $10,080 in federal income tax on their share of the LLC income ($40,000 x 90% x 28%). William would pay $1,400 ($1,736 in 2013) on the remaining $4,000 of net rental income. Thus, the family realizes an income tax savings of $2,520 to $5,544 on an annual and recurring basis. And, there could be additional tax savings at the state level. This annually recurring income tax savings will provide significant family savings over the years. Additionally, at William s death, the 90% LLC interest he gave to his children (and all of the future appreciation in the value of the building held by that LLC interest) is completely excluded from his estate for estate tax purposes. This strategy would also be effective with other types of income-producing property, including after-tax investment securities. To further leverage this strategy, you could gift the property into an irrevocable trust you establish. You determine the trust terms, and the trust can provide an additional layer of control over the use of the property. For example, a central feature of a trust could be creditor and divorce protection for your beneficiaries, as well as the possibility to continually pass assets from one generation to the next without the imposition of estate or generation-skipping tax at each generation. The trust could also provide other nontax advantages such as: (a) gaining privacy over the ownership of family assets, (b) potential reduction of probate and administrative expenses, (c) the enjoyment of seeing the recipients benefit from the gift, and (d) the corresponding opportunity for you to see how well the recipients manage the property. About the authors Doug Rothermich is Vice President of Wealth Planning Strategies, and John O Shea is a Senior Wealth Planning Specialist for TIAA-CREF. Both are frequent speakers on tax and wealth planning strategies, and focus much of their practice on assisting TIAA-CREF participants with such matters. The tax information contained herein is not intended to be used and cannot be used by any taxpayer for the purposes of avoiding tax penalties. It was written to support the promotion of TIAA-CREF Wealth Management Services. Taxpayers should seek advice based on their own particular circumstances from an independent tax advisor. Examples included herein are hypothetical and for illustrative purposes only. Wealth Management Group Services are provided through Advice and Planning Services, a division of TIAA-CREF Individual & Institutional Services, LLC, a Registered Investment Adviser. TIAA-CREF Individual & Institutional Services, LLC, also distributes securities and provides additional brokerage services in its capacity as a registered broker/dealer, member FINRA. TIAA-CREF Trust Company, FSB provides investment management and trust services Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF), 730 Third Avenue, New York, NY C1837B (1/12)

35 TRENDS AND ISSUES SEPTEMBER 2009 NEW ROTH CONVERSION OPPORTUNITIES: IS CONVERTING A TRADITIONAL IRA, 403(B) OR 401(K) A SMART MOVE, UNWISE OR MUCH ADO ABOUT NOTHING? William Reichenstein Baylor University TIAA-CREF Institute Fellow Douglas Rothermich TIAA-CREF Alicia Waltenberger TIAA-CREF EXECUTIVE SUMMARY Roth IRA, Roth 403(b) and Roth 401(k) accounts are essentially mirror images of their traditional counterparts. Instead of offering income tax deferral on funding the accounts and income taxation on withdrawal from the accounts, the Roth accounts allow no income tax deferral benefits when assets are contributed to the accounts, but can allow for income tax-free appreciation inside the accounts and tax-free distributions from the accounts. Recent tax law changes create an opportunity to consider converting a traditional retirement account to a Roth account for many who historically have been unable to take advantage of this planning opportunity due to the significant income limitations imposed on such a conversion. Beginning in 2010, the income limitations that have been in place since the inception of the Roth IRA will be eliminated so anyone with a traditional IRA, 403(b) or 401(k) plan will now be able to make a Roth conversion. While the decision to convert to a Roth account can provide tax savings for some, it is not a wise move for all. The purpose of this Trends and Issues is to discuss the factors that should be considered in determining if the conversion of a traditional IRA, 403(b) or 401(k) to a Roth account is a smart move, unwise, or much ado about nothing. Typically the most important factor is a comparison between the marginal income tax rate in the conversion year and the marginal income tax rate in the withdrawal year if not converted, where this latter tax rate is usually a tax rate from a retirement year. If your future income tax rate is anticipated to be higher, converting to a Roth may be appealing, but if you anticipate your future income tax rate to be lower, converting may be unwise. C45794

36 HISTORY OF ROTH ACCOUNTS Roth IRAs first became available to taxpayers in With the inception of the Roth, Congress effectively created a mirror image of the traditional IRA: contributions to a Roth IRA are never deductible, but the returns are income tax-free. Since the Roth IRA s inception, it has grown in popularity. In 2006, Congress helped add to this popularity when it combined the features of the Roth IRA with the traditional 403(b) and 401(k) plans by implementing the Roth 401(k) and Roth 403(b) accounts. Because the Roth 403(b) and Roth 401(k) accounts allow much larger annual contributions than a Roth IRA - $16,500 (or $22,000 if over age 50) in 2009 for a Roth 403(b)/Roth 401(k), compared with just $5,000 (or $6,000 if over age 50) in 2009 for a Roth IRA there has been a significant increase in the amount of funds inside all Roths since Roth accounts can be established in one of two ways. Contributory Roth accounts are those originally established by making regular contributions to a Roth IRA, Roth 403(b) or Roth 401(k) plan. Since contributions to a Roth account are not deductible for income tax purposes, you pay taxes on these funds in the contribution year. Stated differently, contributions to a Roth account are made with after-tax dollars. By contrast, a Roth conversion is the act of taking pre-tax funds from a traditional IRA, 403(b) or 401(k) account and electing to affirmatively convert these funds to a Roth IRA, Roth 403(b) or Roth 401(k) account. Since the conversion of a traditional account to a Roth account is treated as a distribution of the converted amount for income tax purposes, the amount converted is included in your gross income except to the extent it is treated as a return of your investment in the plan (i.e., if you made non-deductible contributions, those are generally not subject to income tax upon conversion). In the year of the conversion, all converted tax-deferred amounts are subject to income tax; however, thereafter (as with all Roth accounts) the earnings inside the account and distributions from the account can occur income tax-free. Prior to 2010, not all individuals are allowed to elect a Roth conversion. The tax code has historically imposed certain income limitations on those who can make such an election. To make the election, you must have modified adjusted gross income of $100,000 or less and must file your income tax return as either single or married filing jointly (the same income limitation applies to both statuses). 1 In 2010, all previously imposed income limitations on who may elect to convert a traditional IRA, 403(b) or 401(k) account to a Roth account will be removed; there will no longer be an income limitation or a filing status restriction on your eligibility to elect a Roth conversion. These historic income limitations have prevented many individuals from being able to convert a traditional account to a Roth account. As such, a significant percentage of existing Roth accounts consist of contributory Roth accounts. As the income limitations for a Roth conversion are removed in 2010, it is anticipated that the amounts inside all Roth accounts will again swell in 2010 and thereafter as more individuals elect to convert large traditional accounts to a Roth account. 1 To calculate your modified adjusted gross income, begin with your adjusted gross income ( AGI ) and subtract any income resulting from the Roth conversion. Then subtract any amount included in AGI by reason of a required minimum distribution from an IRA or traditional plan. Next, add your and your spouse s full Social Security benefits. Next, any miscellaneous deductions and exclusions are added if they were claimed in your AGI (e.g., deduction for traditional IRA contributions, student loan interest expenses, tuition expenses, foreign earned income and housing costs, income resulting from redemption of U.S. Savings Bonds (Series EE) used to pay higher education expenses, deduction for passive activity losses, and qualified adoption expenses paid by your employer). C45794 TRENDS AND ISSUES SEPTEMBER

37 DIFFERENCES BETWEEN TRADITIONAL AND ROTH ACCOUNTS Traditional IRAs, 403(b)s, and 401(k)s are typically income tax-deferred retirement accounts funded with pre-tax dollars. Funds in traditional accounts grow tax-deferred until distribution. Distributions are taxed as ordinary income (except to the extent they represent a return of your basis in the account), and withdrawals made before age 59 ½ generally subject to an additional 10% penalty tax. 2 You must generally begin taking distributions from your traditional account when you reach your required beginning date ( RBD ). The RBD for a traditional IRA is April 1st of the calendar year following the year in which you attain age 70 ½. The RBD for your qualified plan (such as a 403(b), 401(k) or 457 plan) is generally April 1st of the calendar year following the later of: (a) the calendar year in which you attain age 70 ½, or (b) the calendar year in which you retire from employment with the employer maintaining the plan. 3 In contrast, because you have already included contributions to your Roth IRAs, Roth 403(b)s, and Roth 401(k)s in your gross income, withdrawals of contributions from these accounts are always tax and penalty-free. However, withdrawals of investment earnings and growth from these accounts may be subject to a penalty and/or tax unless the individual meets two requirements. The first requirement is that you must be at least age 59 ½ before taking a distribution from your Roth account. If this rule is met, then there will never be a penalty assessed on the distribution. The second requirement is the 5-year rule, which mandates the length of time that you must leave assets inside the Roth account. If this rule is not met, then the earnings on the account are all subject to income tax in the year of withdrawal. If neither of these rules are met, then the distribution may be subject to both a 10% penalty and income tax on the earnings. Application of the 5-year rule differs between a Roth IRA and a Roth 403(b) or Roth 401(k) account. For all Roth IRAs, the 5-year rule begins on January 1st of the first year that the initial contribution was made to any Roth IRA. All Roth IRAs are essentially aggregated for this purpose. 4 For Roth 403(b)/Roth 401(k) accounts, each plan has its own 5-year rule (even if the same employer maintains the plans). If the individual has multiple Roth 403(b)/Roth 401(k) plans, these plans cannot be aggregated for purposes of the 5-year rule. There is one exception to this rule if you rollover your entire Roth 401(k) or Roth 403(b) plan by direct rollover to another Roth 401(k) plan or Roth 403(b) plan, the starting date for whichever account is older begins the holding period for purposes of calculating the 5-year rule. Finally, if you rollover your Roth 403(b) or Roth 401(k) plan into a Roth IRA, the 5-year period begins on January 1st of the first year you have any Roth IRA account, regardless of whether the Roth IRA held money rolled over from a Roth 403(b) or Roth 401(k) account. The required minimum distribution rules also differ between Roth IRAs and Roth 403(b)/Roth 401(k) plans. With a Roth IRA, you are not required to take any distributions during your lifetime. After death, however, the beneficiary of your Roth IRA must begin taking minimum distributions. By contrast, if you have a Roth 403(b) or Roth 401(k) account, you are required to begin taking minimum distributions once you reach your RBD (where the RBD is the 2 There are several exceptions to the 10% penalty that may apply if you take a distribution from your traditional plan prior to the age of 59 ½ including: disability, qualified higher education expenses, first-time home purchase, medical expenses and distributions in a series of substantially equal payments. 3 A 5-percent owner is someone who owns more than 5 percent of the outstanding stock of the corporation or stock possessing more than 5 percent of the total combined voting power of all stock of the corporation, or if the employer is not a corporation, any person who owns more than 5 percent of the capital or profits interest of the employer. If you meet the definition of a 5-percent owner, then your RBD is April 1 of the calendar year following the calendar year in which you attain age 70 ½ regardless of when you actually retire. 4 For example, if you placed $5,000 in a Roth IRA on November 20, 2010, and do the same each November thereafter, the 5-year rule is met on January 1, Monies contributed on November 20, 2014 can be withdrawn tax-free on January 1, In addition, keep in mind that if you convert a traditional plan into a Roth IRA on January 10, 2015, the converted assets can be immediately withdrawn tax-free because you have already completed the 5-year rule for every Roth IRA you will ever own. C45794 TRENDS AND ISSUES SEPTEMBER

38 same as the traditional 403(b) or 401(k) accounts listed above). As a practical matter, if your Roth 403(b) or Roth 401(k) plan can be rolled over to a Roth IRA, then you can avoid minimum distributions by rolling the account into a Roth IRA (where no minimum distributions are required during your lifetime). WHAT IS A ROTH CONVERSION? A Roth conversion is the act of moving funds from an existing traditional IRA, 403(b) or 401(k) plan to a Roth account. A conversion is a taxable event for income tax purposes. When you convert any portion of a tax-deferred traditional account, you are treated as accelerating the distributions on that account for the converted portion and accordingly, the income tax on those distributions is also accelerated to the year of conversion. You will have to pay income tax on the converted assets in the year of conversion (except to the extent the distribution represents a return of any non-deductible contributions). The tax is paid at your applicable income tax rate. As we shall see, there are several factors that could influence your decision to convert funds. One major factor, usually the most important factor, is a comparison between the marginal income tax rate in the conversion year and the marginal income tax rate in the withdrawal year if not converted, where this latter tax rate is usually a tax rate from a retirement year. This factor is discussed next. Later, we discuss other factors that might influence your decision to convert. COMPARING MARGINAL TAX RATES If you convert funds in 2010, there is a special rule that allows you to spread the income tax recognition from the conversion in equal portions over a two-year period beginning with the tax year This means you will be able to choose between splitting the converted funds into equal halves and reporting each half as taxable income on your 2011 and 2012 income tax returns or reporting the income on all converted funds in For simplicity, we assume you choose to report the income for We later explain that choosing to pay all of the income tax in 2010 will usually be wise; however, we also discuss the option to split the income between 2011 and In our comparison, you must choose one of two strategies. First, convert funds to a Roth IRA and pay taxes this year. Then invest the funds in a Roth IRA for n years at which time the funds are withdrawn and spent. Second, let the funds in the traditional tax-deferred account grow income tax-deferred for n years, at which time the funds are withdrawn. Taxes are paid, and the remaining after-tax funds are spent. As we shall see, you should compare your 2010 marginal tax rate with the marginal tax rate on these funds if you do not convert. This latter tax rate is the marginal tax rate n years hence, which is probably a retirement year. Alternatively, if you die before withdrawing the funds from your traditional account, the funds eventually will be withdrawn and taxes paid at your beneficiary s marginal tax rate. In either case, a key comparison is between the marginal tax rates today if you converted and the expected marginal tax rate at withdrawal in the future if you choose not to convert. (If the income is split between 2011 and 2012, then the first tax rate should be the average marginal tax rate in 2011 and 2012.) Let s compare the after-tax future values of funds held in traditional tax-deferred accounts if converted today (to a Roth account) or if withdrawn from the traditional account in retirement. We initially assume the taxes are paid with the converted funds. For simplicity, let s assume you are deciding whether to convert $10,000 of pre-tax funds in a traditional 403(b) today. Whether converted or not, we assume the funds will be invested in the same asset, which will earn r per year pre-tax rate of return for n years, and the funds will be withdrawn and spent n years hence. If converted, the after-tax value will be $10,000 (1-t) today and $10,000 (1-t) (1+r) n in n years, where t is the 2010 marginal tax rate (or average of marginal tax rates for 2011 and 2012), r is the asset s pre-tax rate of return, and n is the length of the investment horizon. The underlying asset could be stocks, bonds, cash, mutual funds or any other asset. If not converted, the pre-tax value in n years will be $10,000 (1+r) n and the after-tax future value will be $10,000 (1+r)n (1-t n ), C45794 TRENDS AND ISSUES SEPTEMBER

39 where t n is the marginal tax rate n years hence. By comparison, the after-tax future value if converted is $10,000 (1-t) (1+r) n, while the after-tax future value if not converted is $10,000 (1+r) n (1-t n ). If the 2010 marginal tax rate equals the withdrawal year marginal tax rate, t = t n, then these two values are the same. If the 2010 marginal tax rate is lower, t < t n, then you will be able to spend more on goods and services (i.e., have a higher after-tax balance in the accounts) by converting the funds to a Roth IRA today. If the 2010 marginal tax rate is higher, t > t n, then you will be able to consume more goods and services by not converting the fund. Clearly, a key factor in the decision to convert funds is the comparison between the two marginal tax rates. As the following examples show, if your future income tax rate is anticipated to be higher, converting to a Roth may be appealing, but if you anticipate your future income tax rate to be lower, converting may be unwise. Figure 1 illustrates the importance of the two tax rates in terms of their influence on the level of future spending or the net value of the account in after-tax dollars. Without loss of generality, let s assume you will withdraw the funds and spend them after the asset s cumulative pre-tax return is 50%. Column A indicates that if the federal-plus-state marginal tax rates are 25% today, t, and n years hence, t n, then the after-tax future values will be the same. If not converted, the $10,000 pre-tax grows to $15,000 pre-tax in n years. At withdrawal, the after-tax amount is $11,250. If converted, the $10,000 pre-tax becomes $7,500 after taxes in a Roth IRA in The funds grow tax-exempt and are worth $11,250 after taxes in n years. In either case, the $10,000 of pre-tax funds today will finance the purchase of $11,250 of goods and services n years hence. In this example, you may look to other factors to be discussed later to decide whether to convert funds today. As we shall see, many, but not all, of these other factors suggest converting the funds today. FIGURE 1 EFFECT OF TAX RATES ON DECISION TO CONVERT TO ROTH IRA COLUMN A COLUMN B COLUMN C TRADITIONAL ROTH TRADITIONAL ROTH TRADITIONAL ROTH Tax Rate in Conversion Year n/a 25% n/a 30% n/a 20% Tax Rate in Withdrawal Year 25% n/a 20% n/a 30% n/a Pre-Tax Balance $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 Tax on Conversion $0 $2,500 $0 $3,000 $0 $2,000 Balance after Conversion $10,000 $7,500 $10,000 $7,000 $10,000 $8,000 Withdrawal Amount $15,000 $11,250 $15,000 $10,500 $15,000 $12,000 Income Tax on Withdrawal $3,750 $0 $3,000 $0 $4,500 $0 Balance $11,250 $11,250 $12,000 $10,500 $10,500 $12,000 Column B illustrates that if you have a lower tax rate at withdrawal, t n < t, you should not convert funds to a Roth IRA today. In this example, today s tax rate is 30%, while the tax rate n years hence is 20%. If converted today, the $10,000 of pre-tax funds will be worth $10,500 after taxes n years hence, $10,000(1-0.3)(1.5), where 1.5 denotes the cumulative 50% pretax rate of return. If not converted, the $10,000 before taxes will be worth $12,000 after taxes n years hence, $10,000(1.5)(1-0.2). Clearly, if you expect to be in a lower tax bracket in retirement, you should seldom, if ever, convert funds to a Roth IRA today. Column C illustrates that if you are in a lower tax bracket today than you expect to be in at withdrawal, t < t n, you may have compelling reasons to consider converting funds to a Roth IRA today. In this example, today s marginal tax C45794 TRENDS AND ISSUES SEPTEMBER

40 rate is 20%, while the tax rate n years hence is anticipated to be 30%. If converted today, the $10,000 of pre-tax funds will be worth $12,000 after taxes n years hence, $10,000(1-0.2)(1.5). If not converted, the $10,000 before taxes will be worth $10,500 after taxes n years hence, $10,000 (1.5)(1-0.3). Clearly, if you expect to be in a lower tax bracket in 2010 than when assets may be withdrawn either in your retirement or by your beneficiary after your death, you should consider the advantages of converting funds to a Roth account. If converting a traditional account to a Roth account is appealing, you should consider from which assets the income tax due on the conversion should be paid from the converted funds themselves or from other after-tax assets. When possible, you should pay the taxes on the conversion with funds held in a taxable account outside the converted IRA, 403(b) or 401(k). 5 To understand why, let s return to the example in Column A except assume there is a separate taxable account containing $2,500 to pay taxes on the conversion. For simplicity, assume the pre-tax return on the underlying asset is 6% but its after-tax return if held in a taxable account for this taxpayer in the 25% tax bracket would be 4.5%. If the taxes are paid out of the Roth IRA, then the after-tax values of the Roth IRA and taxable account n years hence would be $7,500 (1.06)n + $2,500 (1.045)n. If the taxes on the conversion are paid out of the taxable account then the after-tax value in n years will be $10,000 (1.06)n. That is, the taxable account is withdrawn this year to pay the taxes on the conversion, which leaves $10,000 in the Roth IRA. By paying taxes out of the taxable account, you keep more money in the tax-exempt Roth IRA to grow income tax-free. The higher-ending wealth when taxes are paid from the taxable account reflects the tax-exempt advantage of the Roth IRA. In 2010, you may have a good idea what your 2010 tax rate will be (and a less clear idea of what the average of your marginal tax rates will be in 2011 and 2012). You will likely be more uncertain about what your tax rate will be in retirement. It is important to remember that you have some ability to control when the funds are withdrawn. Required minimum distributions set a minimum level of withdrawals, but you can try to time withdrawals beyond this minimum for years when you are in a low tax bracket. For example, if you have substantial medical expenses exceeding 7.5% of adjusted gross income then these deductible medical expenses may place you in a low tax bracket. By timing large withdrawals for such tax years, you may have some ability to control the future marginal tax rate, t n. OTHER FACTORS As the preceding section illustrates, you should compare the marginal income tax rates in the conversion year with the anticipated marginal income tax rate in the withdrawal year when the funds will be spent. When one tax rate is anticipated to be much smaller than the other, this should help you determine whether conversion is desirable or undesirable. But when the anticipated tax rates are similar, you should consider other factors. This section discusses some of these other factors that may influence your decision to convert funds to a Roth IRA. REQUIRED MINIMUM DISTRIBUTIONS As stated previously, there are no required minimum distributions on a Roth IRA, while there are required minimum distributions from traditional accounts. Therefore, while required minimum distributions will eventually diminish the amount of funds in a tax-deferred retirement plan or IRA, Roth IRAs have the potential to keep growing larger over your lifetime. 6 This factor favors the conversion. TAX DIVERSIFICATION Most taxpayers have more funds in traditional retirement accounts that will eventually be taxed in future years than in Roth accounts. By converting some of the assets held in the traditional account, you can exercise what is referred 5 Note also that if you are younger than age 59 ½, you will likely incur a 10% penalty on any portion of the converted funds you use to pay the income tax liability. If you are older than age 59 ½, you can pay the tax from the converted assets without penalty. 6 Upon death, the minimum distribution rules do apply to the named beneficiary of a Roth plan, although qualified distributions to the beneficiary continue to be income tax-free. C45794 TRENDS AND ISSUES SEPTEMBER