advanced roth ira planning – recharacterizations & other considerations...

Advanced Roth IRA Planning –Recharacterizations & Other

Considerations_________________________________________________________________________________________________

Presented by:Robert S. Keebler, CPA, MST

Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication, including attachments, was not written to be used and cannot be used for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein. If you would like a written opinion upon which you can rely for the purpose of avoiding penalties, please contact us.

> The Surtax Bubble – New issue

> 2010 two-year spread dilemma

> Recharacterizations – General provisions and timeline

> Recharacterizations – Roth Segregation Conversion Strategy

> Recharacterizations – Analyzing recharacterizations

> Tax sensitive investment strategy

> Tax sensitive withdrawal strategy

Advanced Roth IRA PlanningOutline

© 2010 Prepared by Robert S. Keebler, CPA, MST Baker Tilly Virchow Krause, LLPAll Rights [email protected] 2

APPLICATION TO INDIVIDUALS – Tax equal to 3.8% of the lesser of –

1. net investment income for such taxable year, or

2. the excess (if any) of –

A. the modified adjusted gross income for such taxable year, over

B. the threshold amount.

Comment – In 2011 the top rate goes to 39.6% in 2013 this increases to 43.4% an increase of 8.4%

Sec. 1402. Medicare Tax


Taxable Income 2010 2011 - 2012

Top Ratewith Surtax

2013[1]

$ 0 – 16,750 10% 15% 15%

$ 16,750 – 68,000 15% 15% 15%

$ 68,000 – 137,300 25% 28% 28%

$ 137,300 – 209,250 28% 31% 34.8%

$ 209,250 – 373,650 33% 36% 39.8%

Over $373,650 35% 39.6% 43.4%

[1] The top rate with surtax in 2013 is simply the rate shown for 2011 in addition to the surtax rate of 3.8%.

Surtax Bubble

Married Filing Jointly Table


APPLICATION TO ESTATES AND TRUSTS – In the case of an estate or trust - tax of 3.8% of the lesser

of –

1. the undistributed net investment income for such taxable year, or

2. the excess if any of –

A. the adjusted gross income (as defined in section 67(e) for such taxable year, over

B. the dollar amount at which the highest tax bracket in section 1(e) begins for such taxable year ($11,200 in 2010).



THRESHOLD AMOUNT – The term ‘threshold amount’ means:

1. Married - $250,000

2. Single - $200,000

3. Trusts - $11,200



EXCEPTION FOR DISTRIBUTIONS FROM QUALIFIED PLANS - The term ‘net investment income’ shall not include any distribution from a plan or arrangement described in section 401(a), 403(a), 403(b), 408, 408A, or 457(b).

Specific examples of excluded items:•Roth IRAs

•Traditional IRAs

•401(k)

•ESOP

•Profit sharing plans



MODIFIED ADJUSTED GROSS INCOME - means adjusted gross income increased by the excess of –

1. the amount excluded from gross income under section 911 (a)(1) over

2. the amount of any deductions (taken into account in computing adjusted gross income) or exclusions disallowed under section 911(d)6) with respect to the amounts described in paragraph (1).



EFFECTIVE DATES – The amendments made by this subsection shall apply to taxable years beginning after December 31, 2012.

Tax Planning for the New 3.8 Surtax


Who Does the New Tax Affect?

Example 1. John, a single taxpayer, has $100,000 of salary and $50,000 of net investment income for MAGI of $150,000. The 3.8% surtax would not apply because his MAGI is less than $200,000.

Example 2. Mary, another single taxpayer, has $225,000 of net investment income and no other source of income. The 3.8% surtax would apply to $25,000 of income (the lesser of investment income of $225,000 or the excess of $225,000 MAGI over $200,000 “threshold amount”).



Example 3. Terry & Tina, married filing jointly, have $300,000 of salaries and no net investment income. The tax 3.8% surtax will not apply because they have no investment income.

Example 4 .Peter & Paula, married filing jointly, have $400,000 of salaries and $50,000 of net investment income. They will pay the 3.8% surtax on $50,000.

Example 5. Sarah & Scott, married filing jointly, have $200,000 of salaries and $150,000 of net investment income for total MAGI of $350,000. The 3.8% surtax would apply to $100,000 of income (excess of $350,000 MAGI over $250,000 “threshold amount”).



Example 6. Randy, a single taxpayer, age 69, has investment income of $200,000 and is not subject to the surtax. In the following year, Randy has an RMD from his IRA of $125,000. In this case $325,000 of MAGI exceeds the $200,000 threshold and $125,000 is subject to the 3.8% surtax. This is called the surtax “bubble”.

Example 7. The John Smith trust has investment income of $51,000 and no distributions. The amount over the threshold will be subject to the surtax.




The benefit of a conversion of a $500,000 IRA at the 39.6% rate for a client that will be at the 43.4% rate.

Roth Conversion with Inside Funding (tax due to conversion paid with IRA funds) 1

Year After Conversion No Conversion Roth IRA

Conversion Difference Percentage Difference

Investment Balance - 10 Years $ 826,436 $ 901,652 $ 75,216 9.10% Investment Balance - 15 Years $ 1,078,170 $ 1,182,945 $ 104,774 9.72% Investment Balance - 20 Years $ 1,398,741 $ 1,553,125 $ 154,383 11.04% Investment Balance - 25 Years $ 1,804,561 $ 2,040,604 $ 236,044 13.08% Investment Balance - 30 Years $ 2,315,507 $ 2,682,970 $ 367,463 15.87% Investment Balance - 35 Years $ 2,956,149 $ 3,529,967 $ 573,818 19.41%

Outside Funding (tax due to conversion paid with funds outside the IRA)

Year After Conversion No Conversion

Roth IRA Conversion Difference

Percentage Difference

Investment Balance - 10 Years $ 826,436 $ 935,377 $ 108,941 13.18% Investment Balance - 15 Years $ 1,078,170 $ 1,248,787 $ 170,617 15.82% Investment Balance - 20 Years $ 1,398,741 $ 1,667,418 $ 268,677 19.21% Investment Balance - 25 Years $ 1,804,561 $ 2,226,654 $ 422,093 23.39% Investment Balance - 30 Years $ 2,315,507 $ 2,973,787 $ 658,281 28.43% Investment Balance - 35 Years $ 2,956,149 $ 3,972,042 $ 1,015,893 34.37%

1 The assumptions used for this calculation were as follows: A sixty year-old IRA owner; a beginning Traditional IRA balance of $500,000; a taxable investment account beginning balance of $200,000; six percent pre-tax growth rate; and a 4.8% after tax growth rate. These assumptions are the same for each of the charts.

Roth Conversion


Randy, a single taxpayer, age 69, has investment income of $200,000 and is not subject to the surtax. In the following year, Randy has an RMD from his IRA of $125,000 of investment income. In this case $325,000 of MAGI exceeds the $200,000 threshold and $125,000 is subject to the 3.8% surtax. This is called the surtax “bubble”. However, if the distributions were from a Roth IRA rather than from a Traditional IRA, MAGI would be unchanged and the surtax would not apply. Note the chart below:

Tax Planning for the New 3.8 SurtaxExamples

Regular IRA Roth IRA

Investment Income $200,000 $200,000

IRA Income $125,000 $0

MAGI $325,000 $200,000

Less Threshold Amount ($200,000) ($200,000)

Amount Subject to Surtax $125,000 $0

Surtax @ 3.8% $ 4,750 $0

Surtax over 10 years $ 47,500 $0


Suppose David and Debbie would have MAGI of $240,000 in 2013: $140,000 from earnings and $100,000 of net investment income. They convert David’s $500,000 traditional IRA to a Roth IRA.

Now they have MAGI of $740,000, which is $490,000 over the threshold. Their $100,000 of net investment income is the lesser of interest income or the excess over the threshold amount, accordingly $100,000 will be subject to the 3.8% surtax. Here, the 3.8% surtax raises the effective tax on the Roth IRA conversion by $3,800 – 3.8% of $100,000.

© 2010 Prepared by Robert S. Keebler, CPA, MST Baker Tilly Virchow Krause, LLPAll Rights [email protected]


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Suppose that Paul Johnson a 55 year old surgeon has a $1 million traditional IRA, all pretax. He converts to a Roth IRA in 2010 and incurs a $350,000 tax bill, at 35% (Paul’s annual wage income exceeds $750,000).

If Paul has $350,000 in bank CDs, he can cash them in and use the funds to pay the conversion-related tax. In 2013, those CDs might have paid $17,500 in interest (assuming a 5% yield), all of which would be taxed at 43.4%. Instead, Paul will have moved those dollars to convert into a tax-free Roth IRA -he can even put $350,000 into CDs within the Roth IRA.



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Pension and IRAs are Exempt from the Surtax

David and Veronica, age 75, have pension and IRA income of $750,000, $25,000 of tax-exempt income and no taxable investment income. The surtax does not apply regardless of income because they have no net investment income. A Roth conversion will be surtax neutral.



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Roth Distributions are Exempt when Determining MAGI

Gary and Barb, age 69, have pension income of $130,000 and investment income of $115,000 for a total MAGI of $245,000, just below the threshold amount. In 2013, their Roth IRA withdrawal will be $50,000. Because the Roth distribution is tax-free, it does not affect MAGI and the surtax will not apply.



20

RMDs Increase MAGI – “Lesser of” Rule

Art and Pat, age 69, have pension income of $130,000 and net investment income of $115,000 for a total MAGI of $245,000, just below the threshold amount. In 2013, their RMDs from their IRAs will be $50,000, which brings their MAGI to $295,000. This is $45,000 above the threshold amount ($295,000 less $250,000). The surtax will be imposed on the lesser of $45,000 or their net investment income of $115,000. (i.e., $45,000). A 2010, 2011 or 2012 Roth conversion would eliminate the RMDs and the surtax would not apply.



21

Roth Conversions Increase MAGI

Same facts, except that Art converts $200,000 to a Roth IRA in 2013. As such, the Roth IRA conversion will be added to Art and Pat’s MAGI of $295,000, thus increasing the amount to the Medicare surtax from $45,000 to $115,000. This is illustrated below:



No Conversion

$200K Roth IRA

Conversion(1) Investment Income 115,000$ 115,000$ Pension Income 130,000 130,000 IRA Distribution (i.e. RMD) 50,000 50,000 Roth IRA Conversion - 200,000 MAGI 295,000$ 495,000$ Less: Threshold (250,000) (250,000) (2) Excess Over Threshold 45,000$ 245,000$

Amount Subject to Medicare Surtax (Lesser of: 1 or 2 above) 45,000$ 115,000$

Medicare Surtax (3.8%) 1,710$ 4,370$

22

Regular IRA Roth IRA

Investment Income$200,000 $200,000

IRA Income$125,000 $0

MAGI$325,000 $200,000

Less Threshold Amount($200,000) ($200,000)

Amount Subject to Surtax$125,000 $0

Surtax @ 3.8%$ 4,750 $0

Surtax over 10 years $ 47,500 $0


Roth IRA Example


In the 2010 tax year only, taxpayers may spread the taxable income from a Roth IRA conversion over the 2011 and 2012 tax years.>In this case, the taxpayer defers the taxable income over the two years (not the income tax itself).

> For example, a $100,000 Roth IRA conversion in 2010 will result in $50,000 of taxable income being recognized in 2011 and $50,000 of taxable income being recognized in 2012.

>The two-year election is automatic, unless an affirmative election is made to opt-out of the two-year spread.

> Opt-out is “all-or-nothing” election (i.e. no partial election)

>Need to compare deferring the taxable income over 2011 and 2012 and paying income tax at higher rates against paying the income tax in 2010 at lower income tax rates.

Advanced Roth IRA Planning2010 Two-Year Spread Dilemma


Two key issues with the two-spread are:>Setting up “protective” quarterly tax estimates for 2011 and 2012

> The taxpayer will need to take into account the “phantom income” in 2011 and 2012 from the income realized on the 2010 Roth IRA conversion

>Protecting the Roth IRA from a catastrophic decline in value during the two-year spread

> The main problem here is that the Roth IRA could decline to a value lower than the tax liability owed on the 2010 Roth IRA conversion

Advanced Roth IRA Planning2010 Two-Year Spread Dilemma


Assume that Jackie converts $1,000,000 of her traditional IRA to a Roth IRA in 2010.>If Jackie pays the tax over 2011 and 2012 and is in the highest tax bracket in both years (i.e. 39.6%), her total tax liability will be $396,000

> Thus, Jackie will want to pay a “protective” estimate in 2011 based on her 2010 tax liability (unless her 2011 tax liability will be lower) and pay the remainder of the tax when she files her 2011 tax return. For 2012, Jackie will need to pay a “protective” estimate based on her 2011 tax liability (unless her 2012 tax liability will be lower)

>If the Roth IRA declines in value to below $396,000 after October 15, 2011, Jackie will still be responsible for paying the entire tax liability

> Thus, it will be important for Jackie to create a “reserve” (e.g. buy put options, invest in CDs, etc.) in her Roth IRA to protect against a catastrophic decline in value

> NOTE: If the account declines significantly before October 15, 2011, Jackie should recharacterize the Roth IRA conversion (thereby eliminating the tax liability)

Advanced Roth IRA Planning2010 Two-Year Spread DilemmaExample


Taxpayers may “recharacterize” (i.e. undo) the Roth IRA conversion in current year or by the filing date of the current year’s tax return> Recharacterization can take place as late as 10/15 in the year

following the year of conversion

Taxpayers may choose to “reconvert” their recharacterization> Reconversion may only take place at the later of the following two dates:

(1) The tax year following the original conversion OR

(2) 30 days after the recharacterization

Advanced Roth IRA PlanningRecharacterizations – General Provisions

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Conversion Period Recharacterization Period

1/1/2010 First day a 2010 conversion can

take place

2010

12/31/2010 Last day a 2010 conversion can

take place

4/15/2011 Normal filing date for 2010 tax return

10/15/2011 Latest filing date

for 2010 tax return / last day

to recharacterize 2010 Roth IRA

conversion

2011 2012 2013

4/15/2012 Normal filing date for 2011 tax return / date of first tax payment on 2010

conversion

Tax Payment Period

4/15/2013 Normal filing date for 2012 tax return

/ date of last tax payment on 2010

conversion

CAVEAT: Because of adverse market conditions that could occur from the end of the “recharacterization period” to the end of the “tax payment period” (i.e. 10/15/2011 – 4/15/2013), serious consideration should be given to investing in highly-secure liquid investments (e.g. certificates of deposit) to reserve for the tax liability due on the 2010 Roth IRA conversion.

Advanced Roth IRA PlanningRecharacterizations – Recharacterization Timeline

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Example 1: John converts $100,000 to a Roth IRA on January 4, 2010. On October 20, 2010, John recharacterized the entire $100,000 (plus attributable earnings) back to his traditional IRA. Given these facts, John may not reconvert the recharacterized amount (plus attributable earnings) to a Roth IRA until January 1, 2011.

Example 2: Same facts as Example 1, except that John recharacterized the $100,000 (plus attributable earnings) on March 1, 2011. Given these facts, John may not reconvert the recharacterized amount (plus attributable earnings) to a Roth IRA until April 1, 2011.

Advanced Roth IRA PlanningRecharacterizations – Examples


Example 3: Laura converts $250,000 to a Roth IRA on January 4, 2010. On November 30, 2010, Laura recharacterized the entire $250,000 (plus attributable earnings) back to her traditional IRA. Given these facts, Laura may not reconvert the recharacterized amount (plus attributable earnings) to a Roth IRA until January 1, 2011.

Advanced Roth IRA PlanningRecharacterizations – Examples (cont.)

PLANNING POINT: When recharacterizing a Roth IRA, it is important that a separate traditional IRA is set up to receive the recharacterized funds. This is done so that the IRA owner may convert other traditional IRA funds to a Roth IRA during the “waiting period”.


1/1/10 Action 11/30/10 Action 1/1/11 Action 4/15/11 Action 10/15/11 Action 11/30/11 Action 1/1/12 Action

A $100,000 OriginalConversion

$125,000 Hold $130,000 Hold $130,000 Hold $135,000 Hold $130,000 N/A $130,000 N/A

B $100,000 OriginalConversion

$120,000 Hold $120,000 Hold $120,000 Hold $120,000 Hold $125,000 N/A $130,000 N/A

C $100,000 OriginalConversion

$100,000 Hold $100,000 Hold $95,000 Recharacterize $80,000 Reconvert $85,000 Hold $90,000 Hold

D $100,000 OriginalConversion

$ 75,000 Recharacterize $80,000 Reconvert $85,000 Hold $85,000 Hold $90,000 Hold $95,000 Hold

E $100,000 OriginalConversion

$ 75,000 Recharacterize $90,000 Reconvert $85,000 Hold $90,000 Hold $75,000 Recharacterize $80,000 Reconvert

Advanced Roth IRA PlanningRecharacterizations – Comprehensive Example


> Taxpayers cannot recharacterize a portion of a Roth conversion by “cherry picking” only those stocks that decline in value (IRS Notice 2000-39)

> All gains and losses to the entire Roth IRA, regardless of the actual stock or fund recharacterized, must be pro-rated

Advanced Roth IRA PlanningRecharacterizations – “Anti-Cherry Picking” Rule


Value @ Conversion

Current Value

Relative Percentages

(Current)ABC Fund 250,000$ 100,000$ 25%XYZ Fund 250,000$ 300,000$ 75%Total 500,000$ 400,000$ 100%

On January 2, 2010, when John Smith’s IRA was worth $500,000, he converted the entire amount to a Roth IRA. John will owe ordinary income tax on the entire $500,000. The IRA consisted of ABC Fund ($250,000) and XYZ Fund ($250,000). As of April 15, 2011, ABC Fund had declined in value to $100,000, while XYZ Fund had increased in value to $300,000. Thus, the total value of the IRA account declined in value to $400,000.

Even though John would like to recharacterize all of ABC Fund and leave XYZ fund in his Roth IRA, he must allocate the total loss to each fund ratably. Therefore, John may only recharacterize $125,000 (25% x $500,000) of the original conversion amount instead of $250,000, resulting in taxable income of $375,000 ($500,000 - $125,000).

Advanced Roth IRA PlanningRecharacterizations – “Anti-Cherry Picking” Rule Example


Traditional IRAABC Fund: $250,000XYZ Fund: $250,000

Roth IRA #1ABC Fund: $250,000

Roth IRA #2XYZ Fund: $250,000

STEP 1: Convert traditional IRA to separate Roth IRAs for each asset, asset class or investment sector

Advanced Roth IRA PlanningRecharacterizations – Roth Segregation Conversion Strategy


IRSTaxpayerIncome tax liability due on $500,000

conversion amount

April 15, 2011*

* NOTE: Either a tax return or an extension must be filed by this date. Regardless of what is chosen, the tax liability due on the Roth IRA conversion must be remitted by this date in order to avoid late payment penalties and interest.

STEP 2: Pay income tax on Roth IRA conversion



Roth IRA #1ABC Fund: $100,000

(Current Value)

Roth IRA #2XYZ Fund: $300,000

(Current Value)

Traditional IRA #1ABC Fund: $100,000

(Current Value)

Recharacterization of IRA using the value at the date of conversion

(e.g. $250,000)

October 15, 2011*

* NOTE: October 15, 2011 is the latest date for which a 2010 recharacterization can take place (either by filing extensions or by filing an amended return).

STEP 3: Recharacterize Roth IRA conversion



October 15, 2011Refund of overpayment on

recharacterization of Roth IRA conversion

STEP 4: File (or amend) income tax return claiming refund for recharacterization

Taxpayer IRS



Using the facts from the earlier example, instead of converting his entire IRA into a single Roth IRA, John Smith created two separate Roth IRAs, one for each fund. As of April 15, 2011, ABC Fund had declined in value to $100,000 while XYZ Fund had increased in value to $300,000.

As a result of the poor performance of ABC Fund, John chose to recharacterize the Roth IRA that held ABC Fund before he filed his income tax return. The tax savings from John employing the “Roth Segregated Conversion Strategy” can be summarized as follows:

Without Roth IRA

Segregation

With Roth IRA

Segregation DifferenceValue on Date of Conversion 500,000$ 500,000$ -$ Value of Roth IRA after recharacterization 300,000$ 300,000$ -$ Value of Traditional IRA after recharacterization 100,000$ 100,000$ -$ Ordinary Income Recognized 375,000$ 250,000$ (125,000)$ Ordinary Income Tax @ 28% 105,000$ 70,000$ (35,000)$

Advanced Roth IRA PlanningRecharacterizations – Roth Segregation Conversion Strategy Example


In simplest terms, a traditional IRA will produce the same after-tax result as a Roth IRA provided that:> The annual growth rates are the same> The tax rate in the conversion year is the same as the tax rate during the withdrawal years (i.e. A x B x C = D; A x C x B = D)

Advanced Roth IRA PlanningRecharacterizations – Analyzing Recharacterizations


Traditional IRA Roth IRACurrent Account Balance 100,000$ 100,000$ Less: Income Taxes @ 30% - (30,000) Net Balance 100,000$ 70,000$

Growth Until Death 200.00% 200.00%

Account Balance @ Death 300,000$ 210,000$ Less: Income Taxes @ 30% (90,000) - Net Account Balance to Family 210,000$ 210,000$


Tax Rates Stay the Same






Tax Rates Lower in Future Years






Tax Rates Higher in Future Years


Critical decision factors> Tax rate differential (year of conversion vs. withdrawal years)

> Use of “outside funds” to pay the income tax liability

> Time horizon / Need for IRA funds to meet annual living expenses



The key to successful Roth IRA conversions is to keep as much of the conversion income as possible in the current marginal tax bracket

> However, there are times when it may make sense to convert more and go into higher tax brackets



10% tax bracket

15% tax bracket

25% tax bracket

28% tax bracket

33% tax bracket

35% tax bracket

Current taxable income

Target Roth IRA conversion amount

Optimum Roth IRA conversion amount



Advanced Roth IRA PlanningRecharacterizations – Analyzing RecharacterizationsImpact of AMT

In analyzing Roth IRA conversions, one must take the “alternative minimum tax” (“AMT”) into account in order to determine the effectiveness of the conversion

> In some cases, the AMT may result in a effective tax rate on the conversion that is higher than the marginal income tax rate


Advanced Roth IRA PlanningRecharacterizations – Analyzing RecharacterizationsImpact of AMT - Example

Marginal Marginal EffectiveConversion Other Gross Itemized Personal Taxable Ordinary Total Incremental Ordinary AMT Rate on

Income Income Income Deductions Exemptions Income Tax AMT Tax Tax Rate Rate Conversion-$ 75,000$ 75,000$ (17,700)$ (7,300)$ 50,000$ 6,663$ -$ 6,663$ -$ 15.00% 26.00% 0.00%

25,000$ 100,000$ 125,000$ (17,700)$ (7,300)$ 100,000$ 11,113$ -$ 11,113$ 4,450$ 25.00% 26.00% 17.80%25,000$ 125,000$ 150,000$ (17,700)$ (7,300)$ 125,000$ 17,363$ 135$ 17,498$ 6,385$ 25.00% 26.00% 25.54%25,000$ 150,000$ 175,000$ (17,700)$ (7,300)$ 150,000$ 23,613$ 385$ 23,998$ 6,500$ 25.00% 28.00% 26.00%25,000$ 175,000$ 200,000$ (17,700)$ (7,300)$ 175,000$ 30,244$ 1,054$ 31,298$ 7,300$ 28.00% 28.00% 29.20%25,000$ 200,000$ 225,000$ (17,700)$ (7,300)$ 200,000$ 37,244$ 2,179$ 39,423$ 8,125$ 28.00% 28.00% 32.50%25,000$ 225,000$ 250,000$ (17,700)$ (7,300)$ 225,000$ 44,244$ 3,461$ 47,705$ 8,282$ 33.00% 28.00% 33.13%25,000$ 250,000$ 275,000$ (17,700)$ (7,300)$ 250,000$ 52,031$ 4,424$ 56,455$ 8,750$ 33.00% 28.00% 35.00%25,000$ 275,000$ 300,000$ (17,700)$ (7,300)$ 275,000$ 60,281$ 4,924$ 65,205$ 8,750$ 33.00% 28.00% 35.00%25,000$ 300,000$ 325,000$ (17,700)$ (7,300)$ 300,000$ 68,531$ 5,424$ 73,955$ 8,750$ 33.00% 28.00% 35.00%25,000$ 325,000$ 350,000$ (17,700)$ (7,300)$ 325,000$ 76,781$ 5,924$ 82,705$ 8,750$ 33.00% 28.00% 35.00%25,000$ 350,000$ 375,000$ (17,700)$ (7,300)$ 350,000$ 85,031$ 5,913$ 90,944$ 8,239$ 33.00% 28.00% 32.96%25,000$ 375,000$ 400,000$ (17,700)$ (7,300)$ 375,000$ 93,281$ 4,663$ 97,944$ 7,000$ 35.00% 28.00% 28.00%25,000$ 400,000$ 425,000$ (17,700)$ (7,300)$ 400,000$ 101,558$ 3,386$ 104,944$ 7,000$ 35.00% 28.00% 28.00%25,000$ 425,000$ 450,000$ (17,700)$ (7,300)$ 425,000$ 110,308$ 1,636$ 111,944$ 7,000$ 35.00% 28.00% 28.00%25,000$ 450,000$ 475,000$ (17,700)$ (7,300)$ 450,000$ 119,058$ -$ 119,058$ 7,114$ 35.00% 28.00% 28.46%25,000$ 475,000$ 500,000$ (17,700)$ (7,300)$ 475,000$ 127,808$ -$ 127,808$ 8,750$ 35.00% 28.00% 35.00%

ASSUMPTIONS1) Itemized deductions = $5,000 real estate taxes + $10,000 mortgage interest + $2,700 charitable donations2) Filing status = married jointly3) Ages of taxpayers < 65 (neither blind)4) "Effective rate on conversion" = "incremental tax" divided into "conversion income"5) AMT exemption amount = $45,000 (married jointly in 2010)


Advanced Roth IRA PlanningRecharacterizations – Analyzing RecharacterizationsImpact of Post-Conversion Returns

In analyzing whether the decision to convert was worthwhile, the taxpayer must look at the investment performance of the Roth IRA during the post-conversion period

> In this case, a taxpayer would first determine the “incremental income tax liability” by ordering the investment performance of each Roth IRA conversion amount using the current values of the Roth IRAs (preferably as close to the October 15th deadline as possible)

> From this point, the taxpayer would compare this “adjusted incremental effective income tax rate” against what he/she expects to pay on future traditional IRA distributions


Advanced Roth IRA PlanningRecharacterizations – Analyzing RecharacterizationsImpact of Post-Conversion Returns – Example

Assume that an IRA owner converted the following amounts to a Roth IRA in 2010:

IRA #1 100,000$ IRA #2 100,000$ IRA #3 100,000$ IRA #4 100,000$ IRA #5 100,000$ TOTAL 500,000$


Advanced Roth IRA PlanningRecharacterizations – Analyzing RecharacterizationsImpact of Post-Conversion Returns – Example (cont.)

Now let’s assume that the Roth IRAs had the following values at the time of recharacterization:

Conversion Amount

Current Value % Δ

IRA #1 100,000$ 110,000$ 10.00%IRA #2 100,000$ 97,500$ -2.50%IRA #3 100,000$ 105,000$ 5.00%IRA #4 100,000$ 80,000$ -20.00%IRA #5 100,000$ 115,000$ 15.00%TOTAL 500,000$ 507,500$ 1.50%



The first step is to order the post-conversion returns and to assign an “incremental income tax liability” to each conversion amount:

Conversion Amount

Current Value % Δ

"Incremental Income Tax

Liability"IRA #5 100,000$ 115,000$ 15.00% 25,000$ IRA #1 100,000$ 110,000$ 10.00% 27,500$ IRA #3 100,000$ 105,000$ 5.00% 30,000$ IRA #2 100,000$ 97,500$ -2.50% 32,500$ IRA #4 100,000$ 80,000$ -20.00% 35,000$ TOTAL 500,000$ 507,500$ 1.50% 150,000$



The next step is to assign an “adjusted incremental income tax rate” to each conversion amount:

Conversion Amount

Current Value % Δ

"Incremental Income Tax

Liability"

"Adjusted Incremental Income Tax

Rate"IRA #5 100,000$ 115,000$ 15.00% 25,000$ 21.74%IRA #1 100,000$ 110,000$ 10.00% 27,500$ 25.00%IRA #3 100,000$ 105,000$ 5.00% 30,000$ 28.57%IRA #2 100,000$ 97,500$ -2.50% 32,500$ 33.33%IRA #4 100,000$ 80,000$ -20.00% 35,000$ 43.75%TOTAL 500,000$ 507,500$ 1.50% 150,000$ 29.56%

NOTE: The “adjusted incremental income tax rate” is simply the “incremental income tax liability” divided into the current value of the Roth IRA.



The final step is to compare the “adjusted incremental income tax rate” on each conversion amount against the marginal income tax rate at which future traditional IRA distributions would be taxed

> In this case, assuming that the IRA owner would otherwise take future IRA distributions out at a 28% marginal income tax rate, the IRA owner would be prudent in recharacterizing Roth IRA #2, Roth IRA #3 and Roth IRA #4


Integration of Account Tax Structuring with Overall Asset Allocation1) Income Producing Assets in Traditional IRA

2) Capital Gains Assets in Roth IRA or Taxable Account

$250,000$250,000IRA$500,000

Taxable Account$500,000

$250,000 $250,000

Bonds Stock

Advanced Roth IRA PlanningTax Sensitive Investment Strategy


Blue = position the investor would be at under the original 50% stock / 50% bond investment mix.

Purple = additional $85,000 of additional growth the investor would achieve by placing 100% bonds in IRA.

Assumptions: bonds and the stock both generate a 7% return on a pre-tax basis and client is in the 25% ordinary income tax bracket (15% for capital gains purposes).

$1,500,000

$1,750,000

$2,000,000

$2,250,000

$2,500,000

10 11 12 13 14 15

Year

Integrating Account Tax Structuring with Asset Allocation

(100% Bonds in IRA v. 50/50 Mix of Stock and Bonds in IRA)

Option A - 100% Bonds in IRA

$85,000 of additional assets (4% increase)



What is the proper structure between outside and tax preferred assets?

> Outside investments

> IRAs and qualified plans

> Roth IRAs

> Tax deferred annuities

> Deferred Compensation



$1,522,754

$2,071,612

$1,445,247

$1,951,742

$1,484,000

$2,011,677

$1,000,000

$1,200,000

$1,400,000

$1,600,000

$1,800,000

$2,000,000

$2,200,000

10 15Year

Benefit of Integrating Account Tax Struxturing with Asset Allocation

(Different Growth Rates - After-tax)

Scenario 1 - 100% Bonds in IRA Scenario 2 - 100% stock in IRAScenario 3 - 50% Stock/50% Bonds in IRA

Scenario 1: 100% bonds in a Traditional IRA and 100% stock in an outside taxable investment account

Scenario 2: 100% stock in a Traditional IRA and 100% bonds in an outside taxable investment account

Scenario 3: 50% stock / 50% bonds in a Traditional IRA and 50% stock / 50% bonds in an outside taxable investment account

Assumptions: $500,000 IRA balance; $500,000 outside taxable investment account balance; 5.5% interest rate on bonds (100% ordinary income); 2% dividend rate on stock (100% ordinary income) 6.5% growth rate on stock (100% capital gain); 35% ordinary income tax rate; 15% capital gains tax rate; beginning age of 46; ending age of 60



$100,000 beginning cash to invest

28% tax bracket (15% long-term capital gains bracket)

Options:

Corporate bonds (6% annual interest)

Municipal bonds (4.5% annual interest)

Stocks (1% annual non-qualified dividends, 5% growth (100% asset turnover))

$-

$100,000

$200,000

$300,000

$400,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25Year

After-Tax Balance of a Taxable Account(Invested in Stock, Municipal Bonds and Corporate

Bonds)

Stock (50% Turnover) Stock (100% Turnover)

$79,000 of additional assets(27.7% increase)



Four key issues to consider when structuring a distribution portfolio:> Which retirement investment vehicles (tax sensitive account allocation) to

include in the distribution portfolio

> The order in which plan assets should be withdrawn

> Loss harvesting and the specific identification method

> Tactical income tax planning with defined benefit plans, tax-deferred annuities, Net Unrealized Appreciation (NUA), and Roth IRA conversions

Advanced Roth IRA PlanningTax Sensitive Withdrawal Strategy


> Timing is everything – which tax sensitive account allocation should be used first

> Best result comes from withdrawing funds in a manner that produces the most favorable overall income tax consequences.

> Utilize outside accounts first

> Sell high basis assets first

> Utilize traditional IRA to manage tax brackets

> Defer Roth IRA distributions

> Utilize deferred compensation before IRAs (10 year rule regarding state taxation)

> Carefully implement Roth IRA conversions



Principle #1: Determining Which Assets to Withdraw First From a Specific Account Tax Structure>Timing of withdrawals between assets within the same account tax structure (e.g. Traditional IRAs).

>Under this principle, it is assumed that the retiree makes withdrawals of equivalent size from assets within the same account tax structure.

>Optimal order of withdrawal is dependent upon the expected annual rate of return.

>To maximize the withdrawal period, distributions should first be taken from assets with lower annual expected rates of return and then from assets with the higher annual expected rates of return.

>This principle applies only to assets within the same asset class (e.g. Bonds) and not to assets across multiple asset classes.



Principle #2: Determining Which Tax-Favored Account to Withdraw From First>Deals with the timing of withdrawals between tax-deferred assets (e.g. Traditional IRAs) and tax-free assets (e.g. Roth IRA).

>Theory: If a retiree makes equal, after-tax withdrawals from tax-deferred and tax-exempt accounts, the order of the withdrawals between the two accounts will not affect the longevity of the withdrawal period of the two accounts.

>The assets in each account must both be growing tax-deferred at the same rate of return and the income tax rate must remain flat over the period of the analysis.



Traditional IRA First Roth IRA First

Initial balance - Traditional IRA $100,000 $100,000

Initial balance - Roth IRA $100,000 $100,000

Effective federal income tax rate - Traditional IRA 28.00% 28.00%

Annual after-tax cash flow needed $15,000 $15,000

Annual pre-tax withdrawal $20,833 $15,000

Period until exhaustion - Initial asset 5.8 8.8

Period until exhaustion - Remaining asset 14.2 11.2

Maximum withdrawal period (years) 20.0 20.0

No matter which account tax structure is depleted first, the maximum withdrawal period for both account tax structures is the same.



100% Traditional IRA 50/50 Mix

Initial balance - Traditional IRA $100,000 $100,000

Initial balance - Roth IRA $100,000 $100,000

Annual after-tax cash flow needed $15,000 $15,000

Annual pre-tax withdrawal – Traditional IRA (15% tax rate) $8,824 $8,824

Annual pre-tax withdrawal – Traditional IRA (28% tax rate) $10,417 -

Annual pre-tax withdrawal – Roth IRA - $7,500

Annual pre-tax withdrawal $19,241 $16,324

Period until exhaustion - Initial asset 6.4 19.6

Period until exhaustion - Remaining asset 14.9 3.6

Maximum withdrawal period (years) 21.3 23.2

By taking 50% of the annual distribution from the traditional IRA and the other 50% from the Roth IRA, the client effectively lowers his marginal income tax rate. As a result, the client's maximum withdrawal period is extended from 21 to 23 years.



Principle #3: Determining Whether to Withdraw From Tax-Favored Versus Taxable Accounts>Deals with the timing of withdrawals between tax-deferred investment assets.

>Usually advisable to distribute taxable investment assets first followed by tax-deferred investment assets.

>Particularly true if client expects to be in the same or lower tax bracket.

>Tax-deferred investment asset generates a higher annual after-tax return than that of a taxable investment account.



Client, age 62 and single, has a $500,000 taxable account and a $500,000 Traditional IRA

Needs $60,000 annually for living expenses.

Receives $12,000 of Social Security.

Assumptions: Annual return consists of 3% ordinary income (i.e. interest income) and 4% growth, 25% ordinary income tax rate, 15% capital gains tax rate, 85% of Social Security benefits are subject to income tax.

$1,084,493

$1,316,362

$1,633,578

$984,410 $1,005,256 $1,104,059

$-

$400,000

$800,000

$1,200,000

$1,600,000

$2,000,000

65 75 85Age

Benefit of Withdrawing Funds from a Taxable Account FirstBalance at a Particular Year

Withdraw From Taxable Investment Account First

$529,519 of additional assets(50% increase)



Married Filing Jointly

Married Filing

Separately10% Tax Rate $16,750 $8,37515% Tax Rate $68,000 $34,00025% Tax Rate $137,300 $68,65028% Tax Rate $209,250 $104,62533% Tax Rate $373,650 $186,82535% Tax Rate > $373,650 > $186,825

General Order of Withdrawals:Taxable Investments

Traditional IRAs and Qualified Retirement Plans

Roth IRAs and Roth 401(k)s

Tax Deferred Accounts

Roth Accounts

Investment Accounts

2010 Tax Brackets



Pursuant to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, nothing contained in this communication was intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose. No one, without our express prior written permission, may use or refer to any tax advice in this communication in promoting, marketing, or recommending a partnership or other entity, investment plan or arrangement to any other party.

For discussion purposes only. This work is intended to provide general information about the tax and other laws applicable to retirement benefits. The author, his firm or anyone forwarding or reproducing this work shall have neither liability nor responsibility to any person or entity with respect to any loss or damage caused, or alleged to be caused, directly or indirectly by the information contained in this work. This work does not represent tax, accounting, or legal advice. The individual taxpayer is advised to and should rely on their own advisors.


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