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.
