The 11 Pitfalls, Concerns, & Opportunites for Roth Conversion in 2010

When TIPRA (Tax Increase Prevention & Reconciliation Act) passed in 2005, it seemed like the opportunity for Roth IRA conversion would be a good one for some people. No one could have predicted the “perfect storm” of opportunity for Roth Conversion in 2010 that has ensued. Given record lows for the top income brackets, the sizeable government deficit that has mounted, and the Financial Crisis’ effects on account values of deferred retirement savings accounts, Roth Conversion in 2010 may be the largest tax planning opportunity some of us will ever see. Careful analysis should be taken by everyone to weigh whether or not a conversion strategy is right for you.

Given all that, I have found 11 pitfalls and considerations Californians should know about before they begin any analysis. They are:

1. Waiting Period – There is a 5 year waiting period before growth can be accessed on any Roth Conversion. Full income tax is applied if growth is touched prior to the 5 year wait. There is an additional 10% penalty if you are under 59 ½ .

2. The “Do-Over” Rule – Recharacterization can be done if you convert an account to Roth and the value is worth less around the time you are filing your taxes. If the Roth has lost value since conversion, you can recharacterize back to traditional IRA, and then reconvert at the lower value…lowering the tax burden.

3. Paying the Tax on Conversion – Generally, people should have after-tax savings in a separate account to pay for the tax on conversion. Withdrawing from a traditional IRA to pay the tax will cause a penalty for individuals under 59 ½ , and is probably not the best option for those over 59 ½ .

4. Treatment of Non-deductible IRAs – If you have been contributing after-tax dollars to a traditional IRA, the after-tax portion of the account that is converted to Roth will not be taxed (because you have already paid tax on this money). Additionally, you cannot pick and choose which portions or Ira accounts you wish to convert. You have one IRA in the eyes of the government, no matter how many accounts you have, and therefore any after-tax contributions must be converted pro-rata to the sum total of all traditional IRAs.

5. Converting Company Plans 1 – If you have an old 401k (403b or 457) from a previous employer and want to convert it to Roth, be sure to roll it over to IRA first. If you convert directly from 401k to Roth, you will not have the opportunity to recharacterize if the stock market moves against you.

6. Converting Company Plans 2 – If you want to make better use of mixed/non-deductible IRAs, convert before rolling an old 401k (403b or 457) to a traditional IRA. This will allow you to convert a larger portion of the after-tax IRA contribution.

7. Utilizing Tax Losses – This could be a great time to use net operating loss carry-forwards, charitable contribution carry-forwards, non-refundable tax credits, and pass-through losses to mitigate the taxes of conversion. Work with your tax advisor to coordinate this.

8. Financial Aid Loss – When applying for college financial aid, retirement accounts are generally discounted, but income is not. Roth IRA conversion is considered income and is classified this way on all IRS tax forms.

9. Converting SIMPLE IRAs – There is a 2-year holding period requirement on initial contributions to SIMPLE IRAs. Conversion to Roth prior to the 2-year hold could trigger a 10% penalty. Be sure you time this correctly.

10. Split the State Tax not the Federal – If you have the after-tax dollars to pay the tax on conversion, and there is not a need to manage tax brackets for your conversion strategy, you may consider paying the Federal taxes now (which are scheduled to increase) and use the 2-year deferral split option for State taxes.

11. Trying to Coordinate your Tax Advisor & your Financial Advisor – In all seriousness, this is an opportunity which requires the coordination of your financial advisor and your tax advisor. Be sure to include both in a strategy session to work out whether a full, partial, or multi-year conversion plan may be right. They will be able to help you wade through these and other pitfalls.

This is not meant as a do-it-yourself guide. Roth Conversion is potentially a great opportunity, but should be evaluated on an individual basis, given all of the considerations involved.

The preceding should not be construed as tax advice. Be sure to consult your tax advisor before making any decisions.

How will your Social Security be Taxed in Retirement?

In light of a recent Wealth Management Workshop about Social Security that we hosted for our clients, I have found it helpful to review with people the potential taxation of their Social Security benefits in retirement. Many people do not realize how taxation will affect them in retirement, and consequently fail to plan for it properly.

The IRS looks at your “combined income” to determine the taxability of your Social Security benefit. Combined income is calculated by adding your Adjusted Gross Income with any non-taxable interest (such as Muni Bond interest), plus half of your Social Security Benefits. The equation looks like this:

AGI + Non-taxable Interest + ½ Social Security Benefits = Combined Income

If your “combined income” is between $25K and $34K for a single person, or $32K and $44K for a couple, 50% of your Social Security benefit will be taxable.

If your “combined income” is over 34K for a single person, or $44k for a couple, 85% of your Social Security Benefit will be taxable.

As you can see this can become quite significant and should be weighed when planning for retirement income.

Europe’s PIiGS vs.Emerging BRICs

As we have watched the globally economy grapple with Greece’s debt load in the last couple of weeks, it has become clear that international investing in 2010 will be characterized by a tug of war between the struggling Euro-zone and the potentially overbought Emerging Markets.

The investment world loves to use acronyms whenever possible, so let’s be clear. Dubbed the PIiGS, the struggling economies of Portugal, Ireland, Greece, Spain, and to a lesser extent Italy (the small “i”). The basic challenge for Greece is that the decline in world eco¬nomic growth has exposed the declining relative productivity of Greek business. Historically in this situation, the currency of the country would decline and interest rates would be cut. The decline in currency would improve the trade deficit because cheaper goods become more attractive to foreign markets, thus reducing any trade deficit.

Because these countries use the Euro for their currency, they have little to no control on monetary policy—specifically interest rates. The Europe¬an Central Bank remains reluc¬tant to cut rates as low as the Federal Reserve, which would help Greece. The other PIiGS are not in as bad a shape as Greece, but the entire continent has been terribly hit by this recession.

On the other side are the Emerging market BRIC countries of Brazil, Russia, India, and China—with China being the biggest of the capital letters here. To get an understanding of just how large the Chinese market is, consider that it has three of the four largest banks, the two largest insurance companies, and the second-largest stockmarket. Currency issues have been a global concern toward China, with the yuan having been “allowed” to devalue with the US dollar. Both economists and politicians have argued that the value of China’s currency should be much higher given the country’s improving economic performance.

The challenges with Greece will result in a challenge to the rest of Europe and to global liquidity. If this challenge becomes more likely, emerging markets, corpo¬rate bonds, and domestic equities may suffer. China will have the biggest questions to answer of all of the BRICs, with an exploding economy. With regard to the international sector in 2010 the balance will be between the old world and the new.

2010 in the Crystal Ball--Part 3

Thoughts on ...
Tax & Financial Planning

• What to Expect from Retirement Benefits
  • Social Security will be staying as is. While there is usually some cost of living adjustment associated with payments, 2010 will not show an increase.
  • 401k contributions limits are staying as is. While the government has been building in slight increases each year, there will not be any for 2010. Limits will stay a $16,500 maximum, with a $5500 catchup provision for participants over age 50.
  • 401(k) matches are returning. Statistics are showing that ofthose company plans that cut employer contributions, 27% have already become matching again. Look for this trend to continue as the economy continues to stabilize.

• Roth Conversion
  • Be sure to consider whether a Roth Conversion is right for you. 2010 marks the first time that the conversion opportunity is open to EVERYONE. Be sure to avoid potential tax pitfalls of conversion.

• What about the Estate Tax?
  • The current law on estate tax is that there isn't one. The tax expired at the end of2009, but Congress has until September to make a retroactive law, and you can probably bet that something will shake out of Washington between now and then.

• RMDs Return
  • After the financial crisis in the fall of 2008, Congress decided to suspend required minimum distributions from retirement plans. Well, they are back in 2010, so be sure that you are set to continue withdrawing, otherwise you could be penalized.

• Tax Rates--Capital Gains Rates are Still Low ... For Now
  • Capital gains rates are set to increase in 2011, as the government grapples with deficit, but for now, the highest rate is 15 percent for individuals in the 25 percent to 35% brackets. There is no capital gains for individuals in the 10 percent and 15 percent tax brackets pay no capital gains.

• Tax Rates--One of the Lowest Income Tax Rate Eras ... For Now
  • The fact that we are probably in a rising income tax environment (given the fact that we are at near historic low levels for the top income tax bracket), traditional ideas for retirement planning are being rethought. Roth Conversion, Section 79 Plans, and other tax advantaged tools for retirement are becoming more important for business owners.

2010 in the Crystal Ball--Part 2

Thoughts on ...
Your Retirement Savings

• Manage your Retirement Savings
  • Earmark Other Savings While not selling off in last year's panic was the right move for investors, not adjusting holdings-or ignoring them-is not a good move either. Adjusting investment strategy is a good idea not only when markets adjust, but also as your life does. Retirement strategy adjustment becomes even more important as you enter what I call the redzone-about 10 years before through to 10 years into retirement. It's here the risk tolerance becomes a moving target and the sequence of returns can really weigh on your goals. Poor investment performance in the redzone can severely impact the longevity of your savings.
  • Many investors had a disproportionate amount of their money in equities-nearly four in 10 employees ages 56 to 65 had more than 80 percent of their 401(k)s in stock, according to the Employee Benefits Research Institute.
  
• Increase your savings
  • Earmark Other Savings Performance alone will not get you to your goals. Increase your savings rate, especially in 2010, as the market continues to recover from the recent bear market. Recent studies show that in fact the opposite is happening, and many investors have set aside less in their retirement savings accounts.
• Fees
  • Many people do not realize the extra fees they are paying by keeping money in former employer sponsored plans. Rolling over old company plans will probably decrease the amount of administrative fees you are paying. It will also open up freedom of choice for types of investments, allowing you to choose low cost options.
  • Earmark Other Savings
  • There are other investments out there specifically geared for retirement savings which help guard against longevity risk. Earmark other funds for retirement as you enter the redzone. Seek out the best investments from a tax-advantaged standpoint.

2010 in the Crystal Ball--Part 1

I wanted to share my thoughts for the year ahead. This series of blog entries focuses on the economy, retirement savings, and financial planning for 2010 and beyond.

Thoughts on ...
The Economy

• Emerging Markets will still be a major focus for 2010
  • China continues to play the "will-they-or-won't-they" game when it comes to re-valuing its currency. But the figures for 2009 publish by the Economist are astonishing: "real GDP grew by 10.7% year on year in the fourth quarter. Industrial production jumped by 18.5% in the year to December, while retail sales increased by 17.5%, boosted by government subsidies and tax cuts on purchases of cars and appliances. In real terms, the rise in retail sales last year was the biggest for over two decades." You cannot ignore this sector of the global economy
  
• Small business breaks out
  • When you look at past recessions, often it has been small business that has led the way out. I do not think that this recession will be any different, however, I do think that Washington has another mine field to navigate in enticing small business back to job creation and growth. Regulation has been a hot topic recently, and the potential for new national and state regulations and taxes may have companies putting their growth plans on hold. That means no new jobs and continued jobless recovery. This is particularly true for small to medium sized businesses, which have generated about two-thirds jobs on a national scale. Uncertainty about 2010 and beyond simply has business planning in the holding pattern. New workplace rules and higher income tax are just two of the worries.
  
• California Constitutional Convention
  • A push for referendum is gaining a lot of support for calling a constitutional convention here in California. This has the potential to effect positive change in the broken political system in our state. It also has the potential to wreak havoc with the 8th largest economy in world. Just exactly who would be the delegates for such a convention has been a much argued element. This leads us to my next point ...
  
• Will CA continue to foster areas of "economic success" (e.g. Silicon Valley; Hollywood; Agriculture)?
  • With state spending increased from $56 billion in 1998 to $131 billion in 2008, and the state facing a budget deficit of $40 billion (in 2008), the temptation is for the government to tax successful businesses. The danger as that business will relocate to friendlier confines. The state cannot afford to lose those current tax revenues, and the jobs that come with having those companies in-state.

Decade in Review--From a Financial Perspective

Looking back on the last ten years, it seems there may have been a geo-political or economic event to mark each year. From an economist’s standpoint, the decade from 2000 to 2009 is painted with a string of investment bubbles. From an advisory standpoint, I can recall with much clarity the impact that these events had on client relationships. Let’s take a quick look at each year’s main event.

• 2000--Dotcom bust…Get-rich-quick stock bubble bursts. This had a profound effect on California’s economy (particularly the Bay Area), as a large part of the workforce were sent away from jobs that would not return in the same industry sector.
• 2001--9/11…When stock markets reopened on Wall Street after the 9/11 hiatus, the Dow (DJIA) dropped 685 points. A very scary time in America, resulted in a short-term over-reaction on equity markets. Over the long-term, the 9/11 sell-off had close to zero effect on the economy.
• 2002--Accounting Scandals…As detrimental as the Enron & Arthur Anderson (& others) scandal were to the US economy, the legislative response of Sarbanes Oxley certainly has had unintended consequences. While holding executives to a higher standard is a fine idea, this piece of legislation has allowed places like London and Hong Kong to creep closer to NY as the preeminent location for global finance.
• 2003--Iraq War begins…No matter how any of us feel politically about war, the fact remains that it has been costly.
• 2004--President Bush Re-elected…Again, no matter how any of us feel politically, re-election meant staying the course for the US both internationally and domestically.
• 2005--Significant Oil Price Increases…Not sure if oil shocks in 2005 can be described as a bubble, but certainly provided a mixed year for equity markets, with the S&P 500 index creeping up only 3%. Certainly those industries dependent on oil continued to be hurt by prices.
• 2006--Dow Reaches 12,000…Big movement for equity markets in 2006 with the Dow Jones Industrial Average reaching new highs. Additionally, the Democratic Party seized control of Congress in the 2006 mid-term elections.
• 2007--Sub-prime mortgage crisis…First thought to be the only “problem area” for the mortgage business we soon quickly and painfully learned that securitization of those loans meant that no investor knew who was holding the proverbial bag (of bad debt). 2007 also marked the official start of recession.
• 2008--Global Financial Crisis…Markets bounced around quite a bit throughout 2008, but it was not until Lehman Brothers bankruptcy on September 14th that the systemic financial problems were truly revealed. AIG’s would soon follow, and before we knew it, we all became majority shareholders in the insurance giant.
• 2009--The Great Recession…It bears noting just how bad 2008 was: 8of 500 companies on the S&P 500 index posted positive returns and it was only the 5th time in history stocks and bonds had losing years simultaneously. Policymakers have walked a pretty impressive tightrope in 2009. I believe the S&P 500’s “roar-back” in 2009 came from a negative overreaction in late 2008. Real planning and strategy will begin to play a larger part in the process as we move in to 2010 and beyond.