2010 - Your IRS Get Out Of Jail Free Card

Converting Your IRA to a Roth. Many financial advisors over the years have recommended converting your traditional IRA into a Roth IRA so that future withdrawals from the Roth would be free of income tax, whether for you or your heirs.

We all know that withdrawals from a traditional IRA are subject to tax, whether mandatory or voluntary. We are also aware that withdrawals from a Roth IRA, voluntary during the owner’s life and mandatory after death, are not subject to income tax. Trading a taxable account for a non-taxable account seems like a no-brainer. However, there have been two obstacles:

(1) Payment of the income tax on the IRA withdrawal;

(2) Income limitations on taxpayers eligible to make the switch. Taxpayers with adjusted gross incomes of more than $100,000, were not able to make the conversion. However, the 2006 Tax Bill eliminated this limitation for 2010 and beyond. Obstacle #2 is therefore eliminated beginning 2010!

It Gets Better. For 2010 only, taxpayers can elect to defer recognition of taxable income on the conversion. They can report the taxable income in 2011 and 2012, spreading out the taxes that are due. As I understand the new 2010 rules, a taxpayer making an IRA conversion can recognize all the income in 2010 or spread it equally between 2011 and 2012. If the deferral is elected, the last payment of the tax bite can be deferred until 2013.

After 2010, the Roth Conversation can still be made, regardless of income level, but the deferral of income recognition and tax payment will not be available.

What is the Downside of the New Rule? The basic downside of the new rule is the same as before, i.e. paying income tax on the monies withdrawn and rolled into the Roth. Anyway you look at it, you’re paying income taxes sooner than would otherwise be required. This is the price one pays for a permanent avoidance of income tax on Roth withdrawals. Remember that your heirs will be paying income taxes on monies remaining the IRA account at your death, at whatever their personal income tax brackets might be.

To Defer or Not to Defer. If your financial and tax advisors recommend an IRA Conversion, or recommend analyzing the consequences, one of the hookers will be the possibility that income tax rates might change in 2011 and 2012. For that matter, there is always the possibility, even though remote, that Congress might retroactively change tax brackets for 2010. All of these factors need to be taken into account. Individual taxpayers need to assess whether their taxable income is likely to increase or decrease in the future and determine what, if any, offsetting deductions they might claim against a big lump sum of taxable income. High net worth clients should also take into account that paying income tax on IRA’s now gets that money out of the taxable estate, a further saving to the family down the road. While the balance in a Roth IRA account at death might be subject to estate tax if not payable to a surviving spouse, there won’t be the feared double hit: payment of income taxes on monies withdrawn from a traditional IRA to pay estate tax.

Further Complications. Advance income tax planning might be more complicated for some taxpayers who have both after tax and before tax IRA’s. In our experience that is relatively rare, but nonetheless when that situation exists, more involved consultations with your income tax advisors will be necessary to make sure that the IRS rules on withdrawals for rollover purposes are observed.

Estate Tax Considerations. We still don’t know where the estate tax revision and/or extension is going to land. According our sources, the debate appears to be what the future tax rate will be and whether the exemption is going to $3.5 million per person or $5.0 million per person. In any event, there are high net worth clients that will have to continue estate and financial planning on the basis that a portion of their estates are likely to be subject to estate tax at some point. IRA planning is important in minimizing the estate tax bite, as well as income taxes. It is human nature not to realize taxable income any sooner than is absolutely necessary. Moreover, the volatility of the stock market has made advance planning much more challenging. In some respects, taxable withdrawals from IRA’s for Roth Conversions, can be considered a bargain at depressed asset values. All of this, however, is tempered by the need to use outside resources to pay the income tax liability.

Another facet of IRA planning is the ability to use your IRA accounts for charitable contributions without recognizing taxable income. This is particularly advantageous in Michigan. Taxpayers with charitable pledges or serious charitable intentions should explore this opportunity to maximize the tax effectiveness of their gifts, by reducing IRA balances.

Conclusion. The purpose of this newsletter is to highlight a special benefit for 2010 IRA-Roth Conversions. This opportunity is too good to ignore. Moreover, higher income taxpayers that have not considered IRA Rollovers should consult their tax and investment advisors to analyze how this conversation can help preserve wealth for the family. For your estate planning needs and IRA consultations, as they relate to Trusts, Wills and beneficiary designations, please contact Jim Modrall or any of the attorneys listed below.

Donald A. Brandt, Joseph C. Fisher, Thomas R. Alward, Matthew D. Vermetten, Thomas A. Pezzetti, Jr., Susan Jill Rice, Gary D. Popovits, H. Douglas Shepherd, Laura E. Garneau, David H. Rowe, or Nicole R. Graf at (231) 941-9660

©BRANDT, FISHER, ALWARD & PEZZETTI, P.C.
This newsletter is provided for informational purposes and should not be acted upon without professional advice.