Personal Finance


January 29, 2010


Wealthier investors get do-over with Roth IRA rules

Investors who convert a traditional Individual Retirement Account into two or more Roth accounts to make a bet on the market rising can save on taxes if it doesn’t.

The multiple Roth IRAs should be split among different investments, according to Joseph Spada, managing director of Summit Financial Resources in Parsippany, N.J., whose average client has $25 million in net worth. A conversion can be reversed if some of the assets lose value, saving $140,000 in income taxes, for example, on an account worth $1.2 million.

“The IRS is giving you a bucket of mulligans with your IRA,” said John Bledsoe, a Dallas-based estate planner, referring to the term used in golf for a do-over. Investors who convert to a Roth IRA have until Oct. 17, 2011, to undo their decisions and recoup taxes paid, said Bledsoe, author of “The Gospel of Roth,” whose average client has $100 million or more in assets.

The Internal Revenue Service lifted income restrictions this year on converting a traditional IRA to a Roth IRA, meaning U.S. taxpayers making more than $100,000 a year in adjusted income can make the transfer. There’s no limit on conversions if an investor has multiple IRAs or a cap on the amount that can be converted.

Those who switch from a traditional IRA, where taxes are paid only on withdrawals, to a Roth IRA, must pay income taxes upfront in exchange for tax-free withdrawals during retirement. A taxpayer in the top income bracket with an IRA worth $1.2 million would pay 35 percent or $420,000 in federal taxes when converting the account into a Roth IRA this year.

Three-way divide

A $1.2 million account could be divided into three Roth IRAs worth $400,000 each, Spada said. The first account may be invested in fixed income, the second in equities and the third in high-yield bonds. If one fund lost value, the investor would save the 35 percent tax paid on the $400,000 account, or $140,000, by recharacterizing that Roth IRA into a traditional one, Spada said.

“You don’t want to pay the tax on an account that actually went down in value,” Spada said. Undoing the conversion doesn’t change the fact you lost money on your investments, which is why investors shouldn’t take more risk than they normally would when converting to multiple Roth IRAs, he said.

Free look

Theodore Lustig converted his family’s IRA into three Roth accounts with different asset types on Jan. 4. The 55-year-old attorney put the first account in fixed income, the second in oil stocks and the third in U.S. bank stocks.

“You have a free look,” said Lustig, who’s based in Dallas. “You have until October 2011 to see how your investments have performed.”

Lustig said he could reverse the conversion on accounts that decline or, “if everything works out,” pay a lower tax on income from accounts converted in January that rise in value.

“Even if it turns out that I will save taxes by converting, the conversion may still be undone if I just get cold feet or have unforeseen expenses and no longer want to pay the taxes on the income,” he said.

T. Rowe Price Group Inc. says the number of clients making Roth conversions is three times greater this year compared with the same period in 2009, said Heather McDonold, a spokeswoman for the Baltimore-based company, which had $366.2 billion in assets under management as of September 2009.

USAA, which sells financial services primarily to military families, saw a 500 percent increase in Roth IRA conversions in the first week of January compared with the same week last year, said the San Antonio-based company with 7.3 million members.

Four times more

Fidelity Investments has averaged about 4,000 conversions in January 2008 and January 2009, said Michael Shamrell, a spokesman for the Boston-based company. “For January 2010, we are on track to do more than four times that number,” he said.

About 37.5 million American households held a traditional IRA in 2008 with $3.2 trillion in assets. That compares with 18.6 million households and $165 billion in assets with a Roth IRA, according to the Washington-based Investment Company Institute, a mutual-fund trade group.

A Roth conversion works best when an investor can pay the taxes with funds outside the IRA and leave the proceeds to children or grandchildren, said Bill Fleming, managing director in the Private Company Services Group for New York-based PricewaterhouseCoopers.

Let it cook

“The key with the Roth conversion is you need to have it cooking for as long as possible before taking the distributions,” Fleming said. Passing the account to heirs lets it grow tax-free. Future withdrawals are also tax-free. Taxpayers subject to the estate tax in the future should consider converting because paying the tax upfront on the Roth may lower their estate’s value, he said.

Those who are considering donating the money may want to wait to convert to see if Congress renews a provision that expired Dec. 31, 2009, which lets investors over age 70½ generally transfer up to $100,000 each year of a traditional IRA tax-free, according to the IRS. Brokerage houses and investment companies typically don’t charge for conversions and recharacterizations, Bledsoe, the estate planner, said.

Those who file for an October extension on their 2010 tax returns should still pay taxes owed on income from a Roth conversion by April 15, 2011, or interest and penalties may apply, said Kenneth Powell, a tax partner at New York-based Berdon LLP. Investors can still recover taxes paid from the conversion, Powell said.

One-time deferral

The IRS is offering a one-time tax deferral this year on conversions. A taxpayer can choose to pay all the tax in 2010, or split it between tax years 2011 and 2012. Federal tax rates may rise in 2011 to as high as 39.6 percent, up from 35 percent, when tax cuts instituted by President George W. Bush expire.

That means investors may want to report all the income from the Roth conversion in 2010 to avoid paying higher taxes in following years, Bledsoe said.

“They wanted to kick my shins when I first told them how much they would have to pay,” said Bledsoe, of his 25 clients who have transferred $2 million each in IRAs to Roth IRAs this month. “The reality is they’re under no obligation. Convert now and analyze later if you need to undo it, when you have all the facts about account performance and next year’s tax rates.”


January 29, 2010