Keys To The IRA Kingdom

With 2011 now here, the buzz about the Roth IRA conversion grows louder by the second. January 1 is the blast off date for IRA owners who have incomes over $100,000 to be eligible to convert their traditional IRAs to the Roth IRA and everyone is getting into the game. I just did Google™ search for (Roth IRA Conversion) and found 1,720,000 web-sites, many of them encouraging IRA owners to convert their IRAs to a Roth IRA with their firm. Many of us in the financial services industry are receiving dozens of e-blasts weekly from financial marketing firms touting they can teach us how to take advantage of the “Roth Conversion Bonanza”.

So what’s the buzz all about and why are so many financial firms gearing up to get their share of Roth conversion bonanza? One reason might be because the fees, loads and commissions associated with managing the trillions of dollars of qualified assets in America is big business. On March 10, 2009 Anthony W. Ryan, Assistant Secretary to the US Department of the Treasury stated, “The total value of our nation’s retirement savings has been estimated at $11Trillion.” Beginning in 2010 much of that savings will become eligible to be converted to a Roth IRA. Before we begin the wholesale conversion of tradition IRAs and eligible 401(k) plans to the Roth IRA let’s examine the facts.

The Bonanza

The Tax Increase Prevention and Reconciliation Act of 2005, allows individuals with incomes over $100,000, to convert their traditional IRAs to a Roth IRA as of Jan. 1, 2010. Those who choose to convert in 2010 will be able to pay ½ of the conversion tax in 2011 and the remaining half in 2012. Those who convert after 2010 will pay all of the conversion tax in the following year.

There is an INCOME TAX SALE. We are currently in historically low tax brackets so those who convert now will pay no more than 35% Federal Income Tax on the amount converted. It is widely anticipated that income taxes will increase by 2011.

For many Traditional IRA owners the Roth conversion offers a number of advantages. Roth IRA owners and spouses are not forced to take distributions while they are living and any growth and future distributions to their heirs will be income tax free. This can allow them to pass more money to their children and grandchildren income tax free. For example: A 60 year old who has a Traditional IRA balance of $300K, must begin taking Required Minimum Distributions by April 1 of the year following the year he turns age 70 ½. Assuming it grows at the rate of 5%, the IRA will be worth $488,668 when he turns 70. If the account continued to earn 5% and the owner took only his Required Minimum Distributions and died at age 85 there would be $491,306 of taxable money left to be passed on to the heirs.

Converting to a Roth – Tax paid out of the IRA

If the same IRA owner converted to a Roth now, and paid conversion tax at the rate of 33% out of the IRA there would be $200,000 left in the account. But now the owner will not be required to take any distributions during his lifetime. If no distributions are taken and the account continued to grow at 5%, there will be $677,270 of income tax free money left for the heirs. ($200,000 X 5% X 25 years = $677,270). That means the heirs will inherit $185,964 more and it will all be income tax free. What happened in this case is the owner lived long enough (25 years) after the conversion to recoup the taxes paid at the time of the conversion and then some. If the IRA owner didn’t need or want to take distributions and the goal was to pass as much to the heirs as possible converting to a Roth makes sense. The heirs would inherit more and the income from the inherited Roth IRA will be income tax free.

Converting to a Roth – Tax paid from Non-IRA Funds

If the owner was in a position to pay the conversion tax from Non-IRA funds he then would have a$300,000 Roth IRA and the amount of tax free money passed on to the heirs would have increased to $1,015,906. ($300,000 X 5% X 25 years = $1,015,906). That’s $338,636 more than they would have inherited if the owner had chosen to pay the conversion tax from the IRA. Additionally for some IRA owners, converting to a Roth will reduce their taxable income and could reduce or eliminate the taxation of their Social Security Benefits.

Annuities are a great vehicle for the Roth conversion because they are not subject to Market fluctuations and have historically yielded 5% or better over the long run. For Annuity producers, the Roth conversion can truly be a Bonanza.

The Minefield

What looks attractive today is not guaranteed for tomorrow. In 1934 President Roosevelt made a promise to the American people. No income tax on your Social Security Benefits. In 1983 Congress broke that promise and today many retired Americans are paying income tax on 85% of their Social Security Benefits. Could this happen to the tax free income benefits of the Roth IRA? Of course it could!

Older IRA owners and those who die prematurely may not have enough time to recoup the tax paid on the converted IRA. In this case the heirs could wind up with less inheritance than they would have had the owner chosen not to convert.

Current and future tax brackets of the IRA owner and their beneficiaries could impact the value of converting to a Roth.

Annuities are a great vehicle for the Roth conversion but this must be done properly. If you transfer all of your client’s Traditional IRA to an annuity today and later convert it to a Roth, the outcome could be disastrous. If the IRA owner doesn’t have sufficient Non-IRA money to pay the tax on the conversion, where will the tax dollars come from? If they remove the needed tax money from the annuity, they will likely pay an unwanted surrender penalty. The best approach is to leave a portion of the IRA equal to the estimated conversion tax in a short term liquid account and transfer the balance to the annuity. When the conversion to the Roth occurs a 1099 will be generated by the insurance company. The money will be readily available to pay the conversion tax. Converting to a Roth can be like paying the tax on the seed and saving the tax on the crop. It can be a positive financial move depending on when the crop will be harvested. Now that we know the ground rules, let’s look at the characteristics of the ideal prospect and the wrong prospect for the Roth conversion.

5 Signs of the Ideal Prospect for the Roth Conversion

1. The owner or spouse is expected to live a minimum of 10 years after the conversion. This will assure, at a reasonable rate of return, that the conversion taxes will be recouped prior to death.
2. There are sufficient Non-IRA funds available to pay the conversion tax so the taxes won’t have to be paid out of the IRA.
3. The IRA owner has enough income and will most likely not need income from his IRA.
4. Their goal is to pass more money to the heirs and eliminate the income tax upon distribution.
5. The IRA owner fully understands both the Positive and Negative Tax Consequences of converting to a Roth IRA.
   

5 signs of the Wrong Prospect for the Roth Conversion

1. The owner and spouse are at an advanced age or are in poor health and may not live long enough to recoup the conversion tax.
2. Their IRA represents most of the owner’s savings and the conversion tax will need to be paid out of the IRA funds.
3. The IRA owner will need income from their IRA for the foreseeable future.
4. The IRA owner’s goal is to not outlive their savings.
5. The owner has low to median low net worth and has concerns about having enough savings for a comfortable retirement.
   

Roth IRA Conversion Consumer Awareness

According to Warren Hersch, Senior Editor of the National Underwriter, 67% of IRA owners aren’t aware that the converted funds are subject to income tax and only 9% are planning to convert in 2010. Published 8/31/2009.

This is a strong indication that the majority of IRA owners are not up to speed on the new Roth conversion rules and may not be aware that those with incomes over $100,000 will have the opportunity to convert their traditional IRAs to a Roth IRA in 2010. The best cure for lack of awareness is the highly trained Financial Advisor. TIPRA and the Roth conversion can be a blessing for some IRA owners and the wrong move for others.

Somewhere between the Ideal prospect and the Wrong prospect for Roth IRA conversion there is the great gray area where the majority of IRA owners can be found. For many of these IRA owners a partial Roth conversion may be the best solution. Only highly educated advisors who are well trained in all of the IRA and Roth IRA distribution rules will be in a position to make the difference. So is this the Roth IRA Bonanza or a Minefield?

I suggest it is both!