David First, Tax & Business Partner, Quoted in Bloomberg.com Article – Tax Deal Gives Wealthy Interest-Free Loans for Roth IRA Switch
By Alexis Leondis,
The extension of current income-tax rates gives wealthy taxpayers the equivalent of an interest-free loan if they convert a regular Individual Retirement Account to a Roth by Dec. 31.
Investors in traditional IRAs pay taxes up front on conversions to Roth IRAs to get tax-free withdrawals later. Earners in the highest tax brackets who expected rates to rise next year were faced with reporting all the additional income from conversions on their 2010 returns. With the tax legislation, wealthy savers can now defer and use those tax dollars to earn something, according to Christine Fahlund, a senior financial planner at Baltimore-based T. Rowe Price Group Inc.
“It’s the deal of the century,” said Ed Slott, a certified public accountant in Rockville Centre, New York, and founder of website irahelp.com. “It’s like Congress is giving you an interest-free loan to build a tax-free savings account.”
This year taxpayers can choose to report the taxable income from the conversion in 2010, or split it equally between 2011 and 2012. Federal income-tax rates were set to rise in 2011 to as high as 39.6 percent, up from 35 percent, when tax cuts instituted by President George W. Bush were to expire. The Senate passed an $858 billion tax-cut plan Dec. 15 that would keep existing tax rates through 2012. The House voted 277-148 for final passage.
That means a taxpayer in the top income bracket with an IRA worth $1.2 million would likely pay 35 percent or $420,000 in federal taxes when converting the entire account to a Roth IRA this year, according to Fahlund. They would have paid $475,200 if income tax rates had increased in 2011 to 39.6 percent, or $55,200 more in taxes.
New York Taxpayers
Conversions work best for savers who know they’re going to be in as high or higher tax brackets in the future, and can pay the taxes with money from outside the IRA, said James Lange, a Pittsburgh-based certified public accountant and author of “The Roth Revolution: Pay Taxes Once and Never Again.”
Deferring the income from conversions made this year makes sense for most taxpayers who will be in the same or lower tax brackets in 2011 and 2012, said Slott, the accountant.
For New York taxpayers, there’s a potential additional benefit of deferring, saidMitch Drossman, national director of wealth planning strategies for New York-based U.S. Trust, which manages almost $300 billion in client assets. New York state income-tax rates rose to as high as 8.97 percent from 6.85 percent in 2009 and are scheduled to fall back to 6.85 percent in 2012. That means savers can defer the income to a time when they may have lower tax rates, Drossman said.
No Income Restrictions
The Internal Revenue Service lifted income restrictions this year on converting to Roth IRAs from traditional IRAs, meaning taxpayers making more than $100,000 a year in adjusted income can make the change. There’s no cap on the amount that can be converted to a Roth IRA from a traditional IRA.
It’s too early to know whether taxpayers are electing to report the income on 2010 conversions on their 2010 returns or wait until 2011 and 2012. They have until April 15, 2011 plus any extensions to decide, said Fahlund of T. Rowe. The firm saw more than a fourfold increase in the number of investors converting in 2010 through November compared with a year earlier, she said.
Vanguard Group Inc. based in Valley Forge, Pennsylvania, has seen a fivefold increase in the number of Roth IRA conversions this year to about 150,000 as of the end of November compared with 2009, said Maria Bruno, who specializes in retirement and retirement income for the largest U.S. mutual- fund manager. USAA in San Antonio has seen a fourfold increase in members converting some or all of their traditional IRA assets to a Roth IRA through October, said Kevin O’Fee, assistant vice president of USAA Retirement Strategies.
The taxes owed on switching to a Roth IRA from a regular IRA depend on whether the assets being transferred are pre- or post-tax dollars. If tax-free dollars are included, converters will pay income-tax rates on a percentage of the conversion amount, said Slott, the accountant.
Savers who expect to be in a lower tax bracket in 2010 than in 2011 or 2012 shouldn’t defer the income from the conversion, said David M. First, a tax partner at accounting and advisory firm Marcum LLP in New York. And those who are going to be affected by the alternative minimum tax in 2010 and not in 2011 and 2012 may also want to report the income in 2010, First said.
Since the default option set by the IRS for those who switch is splitting the income between 2011 and 2012, wealthy taxpayers opting to defer don’t have to do anything, according to John Bledsoe, founder of John Bledsoe Associates, an estate and tax planning firm in Dallas, Texas, whose clients have an average net worth of at least $10 million.
“For most people, advising them not to convert now is like telling them to not wear a seat belt while driving,” Bledsoe said. “There’s no logic for not doing it.”
When converting to a Roth IRA, savers should try to avoid converting so much in one year that it bumps them into a higher tax bracket, said Fahlund of T. Rowe. One option is to do partial conversions so the income is smaller, she said.
Investors who later change their minds about a Roth IRA have until October 2011 to undo the switch. Savers may also want to set up more than one Roth IRA to invest separately in stocks and bonds so they can undo a particular portion of the conversion if an asset class performs poorly, said Drossman of U.S. Trust.
For savers age 70 and a half and over, the tax bill includes a provision that allows them to give up to $100,000 from a traditional IRA directly to charity without incurring taxes.
In 2010, donors had to include the distribution as income and received a charitable income-tax deduction for their gifts. The bill would restore the exclusion from income retroactive to the beginning of 2010 and extend it to 2011 as well, said Kim Wright-Violich, president of San Francisco-based Schwab Charitable.