Retirement Watch : Roth IRA

Who Will Benefit from Your IRA?

Bob Carlson — Fri, 25 Sep 2009 00:17:00 GMT

One of the most important decisions about an IRA is naming the beneficiary or beneficiaries. There are many candidates for the biggest mistake made by IRA owners, and a leading contender is the failure to name a beneficiary or naming the wrong beneficiary.

If no beneficiary is named, the estate is the beneficiary. When an estate or another non-individual is a primary beneficiary, the entire IRA must be distributed within five years after the original owner's passing. The estate, as the beneficiary, will owe income taxes on the distributions, in addition to any estate taxes due on the value of the IRA. An IRA owner should never fail to designate at least one qualified individual as primary beneficiary and should never name the estate or other non-individual as a primary or contingent beneficiary. The only exceptions are when there is no interest in allowing heirs to use the tax deferral of the IRA and for certain trust that are allowed to defer distributions.

Since new regulations were issued in 2001 and 2002, the choice of beneficiary is not fixed and does not affect required minimum distributions. The major consideration in naming the beneficiary is: Who should receive the IRA in light of the goals, tax issues, and any other factors that are important to the owner?

After deciding on the primary beneficiary or beneficiaries, the owner also should name contingent beneficiaries. These are people who inherit if the primary beneficiaries are not available or disclaim the inheritance. Naming contingent beneficiaries can be part of a good strategy. The estate executor names the Designated Beneficiary of an IRA by the end of September of the year after the owner passed away. The DB's age determines the required minimum distributions for the IRA. The DB must be on the list of primary or contingent beneficiaries.

Naming contingent beneficiaries allows the executor and heirs to adjust the estate plan if circumstances have changed. Primary beneficiaries who believe it is best for the family that someone else inherit the IRA can disclaim their rights. Disclaimers can continue until the "right person" is available to be named DB. That cannot happen unless contingent beneficiaries are named.

Customized Beneficiary Forms

When naming beneficiaries, it often can be best not to use the Beneficiary Designation forms provided by IRA custodians. A number of estate planners draft their own forms and have them reviewed and approved by the custodians.

One value to a custom beneficiary form is it allows the owner to name more than one primary beneficiary and leave them unequal shares, something that often is difficult or not possible with standard forms. A custom form ensures that the form lists all the beneficiaries the owner wants named. Another benefit to a custom form is, if there are disclaimers or premature deaths of beneficiaries, contingent beneficiaries will succeed primary beneficiaries in the desired order and not in an order dictated by the IRA custodian.

While a standard form might work for many people, those with multiple beneficiaries or less-than-standard situations should consider having their estate planners draft custom forms and file them with the IRA custodian.

The IRA owner also should consider who would receive the share of a beneficiary who dies prematurely — either before inheriting a share of the IRA or after distributions to heirs begin. Should the share go to the children of the beneficiary, or should it be shared by the other primary beneficiaries? Or should it go to a different contingent beneficiary?

The choice is up to the IRA owner, but it has to be stated in the designation form. Otherwise, most IRA custodians have a default position they implement absent instructions from the IRA owner. State law also might establish a default position. The IRA owner should consider the issue and make the choice clear in the designation form.

Another issue: Suppose a beneficiary or contingent beneficiary is young or cannot be trusted to handle the IRA properly. Then, it might be appropriate to name a trust as the beneficiary of the IRA. Naming a trust also is appropriate when the intended beneficiary has special needs.

A trust that is an IRA beneficiary must have precise terms in order to take advantage of the IRA’s tax deferral. With the wrong trust terms, the IRA balance must be distributed and taxed on an accelerated schedule. The help of an experienced estate planner is needed to set up the trust properly.

Splitting IRAs

When there are multiple objects of affection, one option is to name them as joint primary beneficiaries. An alternative is for the IRA owner to split the IRA into separate IRAs, naming a separate beneficiary and a group of contingent beneficiaries for each. IRS regulations allow beneficiaries who jointly inherit an IRA to split it. Yet, not all beneficiaries know about this right or are able to agree to execute it. The owner might find it wise to split the IRA now rather than leaving that to the estate administration process.

I frequently emphasize that an estate owner who plans to leave something to charity should consider using the IRA to do so. Unlike other beneficiaries, the charity will fully benefit from the IRA. Charities are tax-exempt. A charity can withdraw the entire IRA balance and not owe income taxes on it. In addition, naming a charity as beneficiary avoids the estate tax. The IRA is included in the estate, but there is an offsetting charitable contribution deduction for the amount left to the charity.

Because non-charitable heirs benefit more by receiving non-IRA assets, leaving the IRA to a charity can be a good deal for all involved. When the estate owner plans to leave part of the estate to charity and there are enough non-IRA assets for other beneficiaries, the owner should consider leaving all or part of the IRA to charity while leaving the other assets to non-charitable beneficiaries.

When considering IRA beneficiaries as part of an estate plan, there are a couple of other strategies I frequently recommend that you should consider as alternatives.

One strategy is to avoid all this by emptying your IRA early. Distribute all or most of the IRA, pay the taxes, and invest the after-tax amount. That gives you more flexibility over how to give away the balance and probably gives the heirs a larger after-tax amount in the long term. This can be appropriate for someone with a large IRA and other income or assets to maintain the standard of living. It also is best if you expect the after-tax account to have 10 years or more to growth and compound before money is withdrawn.

Another strategy is to convert the traditional IRA into a Roth IRA. This does not avoid the choice of beneficiary, but it makes the distributions tax free. Keep in mind it costs money to convert to a Roth IRA.

I have discussed the details of both of these strategies in past issues of Retirement Watch and in my book, The New Rules of Retirement.

Designating IRA beneficiaries is a neglected step in many estates. Take care to designate beneficiaries with care and use a custom beneficiary designation form if necessary. Taking these steps can increase the after-tax wealth of your heirs by tens of thousands of dollars. A will or living trust has no influence on who inherits your IRA or other qualified retirement account. Only the beneficiary designation form counts. Make your designations carefully, update them as needed, keep copies of all forms, and be sure the executor knows where the forms are.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com. He also is author of the books The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Your IRA and Your Heirs

Bob Carlson — Fri, 29 May 2009 20:22:00 GMT

The unfortunate fate of many IRAs shows why everyone needs an estate plan, even when the value of the estate is far below the taxable level. Few people are aware of what could happen to their IRAs when the next generation inherits them. Most people, and discussions of IRAs, focus on building the balance through contributions and investments. If your IRA is a meaningful portion of your estate, however, you better consider what will happen to it. Effective estate planning strategies for IRAs tend to be different from the rest of the plan.

An estate plan for IRAs should answer these questions: What will be the bills for estate taxes and income taxes? Who will pay those taxes? Who will receive the IRA? In what form will the IRA be received?

There is a great deal of confusion about how inherited IRAs are taxed. The value of the IRA will be included in the owner's estate. Unlike other assets, ownership of the IRA cannot be given away during life or put into a trust for the benefit of others. If the IRA owner's estate will be large enough to incur estate taxes, the owner has to use other assets to reduce the tax or purchase life insurance to pay the estate tax. Most likely the IRA also will incur any state death or inheritance taxes.

Estate taxes can be avoided when the surviving spouse is the sole primary beneficiary of the IRA. The IRA’s value will be included in the owner’s estate, but there will be an offsetting marital deduction when the spouse inherits.

When estate taxes are incurred on an IRA the next issue is: Who pays the taxes attributable to the IRA?

Most standard wills provide that estate taxes are paid from the residuary estate or from the surviving spouse's share. Other estates apportion the taxes against specific assets or shares of the estate. If the IRA is a large percentage of the estate and taxes are paid from the residuary estate or surviving spouse's share, the taxes attributable to the IRA could really shrink the after-tax value of the shares paying the taxes.

Having the taxes attributable to the IRA paid by the beneficiaries of the IRA could create problems. If the beneficiaries do not have sufficient other assets to pay the taxes, they will have to take a distribution from the IRA to pay the taxes. The distribution will be included in their gross income for income tax purposes, so they will have to take an extra amount to pay the income taxes on the distribution they take to pay the estate taxes.

The best solution depends on the particular estate and the beneficiaries. The IRA owner should take care to consider how much the estate taxes will be and which part of the estate will pay them or whether life insurance should be purchased to pay the taxes.

After the payment of estate taxes isre resolved, or even if estate taxes are not an issue, there are income taxes to consider.

Unlike when other assets are inherited, there also will be income taxes due when the beneficiary takes distributions from the IRA. The beneficiary pays the same income taxes on distributions that the owner would have paid. These taxes cannot be avoided, and the fact of them might influence who is named beneficiary of the IRA or how much is left to different beneficiaries.

A non-IRA asset is more valuable to an heir than an IRA of equal value is, because there will be income taxes due on distributions from the IRA. The heir really inherits only the after-tax value of the IRA. The non-IRA asset, on the other hand, can be sold and no capital gains taxes would be due on the appreciation that occurred during the owner's holding period.

The income taxes due on IRA distributions are a reason to consider making charitable gifts with the IRA instead of other estate assets. The IRA will be included in the estate, but there will be an offsetting charitable contribution deduction, for no net estate tax. In addition, a charity that is named beneficiary of an IRA will not owe income taxes when it takes distributions, so it will benefit from the full value of the IRA. If there is an inclination to make charitable gifts through the estate, it often is better to make the gifts through an IRA and maximize the non-IRA assets left to other heirs.

You do not have to leave the entire IRA to a charity. If the IRA’s value exceeds the amount you want to leave to charity, leave a portion of the IRA to charity and a portion to other heirs. Or split the IRA into two, leaving one entirely to charity and the other to other beneficiaries.

Another issue is the beneficiary selection, if it is not to be a charity. An IRA owner wants to be sure to name one or more beneficiaries. Failure to do so, or naming the estate as beneficiary, removes the tax deferral benefits of the IRA. Distributions will be required from the IRA on an accelerated schedule.

Naming the beneficiary is not as complicated as it used to be. Before 2001 and 2002 regulations, the beneficiary choice greatly influenced the amount of the required minimum distributions during the owner’s lifetime. Now, an IRA owner should consider only which beneficiary he or she really wants to receive the IRA.

In most cases, the surviving spouse is the primary beneficiary and the children are contingent beneficiaries. In larger estates, the owner might name a charity to receive at least some of the IRA as discussed above.

Yet, it makes a lot of sense for an IRA owner to have a back up plan for the beneficiary selection. The regulations allow the estate executor to name the Designated Beneficiary by September 30 of the year after the year of the IRA owner's death. In most cases, there won't be any reason to change from the standard practice of naming the surviving spouse as beneficiary. But circumstances can change, and the regulations allow the executor to adapt to changing circumstances.

For the executor to take advantage of the flexibility, the IRA owner must name contingent beneficiaries on the beneficiary designation form. The Designated Beneficiary named by the executor must be on the list of primary and contingent beneficiaries named by the owner.

When more than one person is beneficiary of an IRA, the beneficiaries can split the IRA into separate ones, but they might not realize this or the IRA custodian might be resistant to it. If the beneficiaries do not split the IRA, the age of the oldest determines the required minimum distributions from the IRA. In addition, the beneficiaries have to agree on management of the IRA and on the policy for taking distributions that exceed the required minimum.

The IRA owner should ensure that the beneficiaries know they can split the IRA. The owner also should check the IRA custodian’s policy for splitting inherited IRAs. Some discourage it or charge fees. Some IRA owners decide to split their IRAs themselves, naming one primary beneficiary for each.

Instead of leaving the IRA directly to individual beneficiaries, the owner might want to name a trust as beneficiary. The trust can control when distributions are made to the beneficiary. This arrangement might increase income taxes, however, and tricky rules must be followed when drafting the trust. Do not name a trust as IRA beneficiary without working with an estate planning attorney who is experienced in this area. The wrong language in the trust can terminate the tax deferral benefits of the IRA and require distributions on an accelerated schedule.

Because of the income and estate taxes and the nuances of naming beneficiaries, some IRA owners choose to empty their IRAs early, pay the taxes, and invest the after-tax assets in taxable accounts. Once out of the IRA, the assets can be given away as part of the estate plan or can be invested for long-term gains.

Emptying the IRA early generally is a strategy for those who have sufficient assets outside the IRA to support their standard of living or have such large IRAs that they consider the IRA primarily a savings account or something to be left to the next generation. If the strategy is used, it is best to empty the IRA as early as possible, because time is needed to make up for paying the income taxes early. I discuss the strategy in detail in my book, The New Rules of Retirement and have discussed it in past issues of Retirement Watch.

For similar reasons, people convert traditional IRAs into Roth IRAs, which also is discussed in those sources.

IRA owners need to know that wills and living trusts have no effect on an IRA. Only the beneficiary designation form on file with the custodian determines who inherits an IRA. IRA owners need to keep copies of the form and review it regularly. They also should check with the IRA custodian to be sure it has the current form on file.

A Dangerous Retirement Myth

Bob Carlson — Fri, 17 Apr 2009 14:15:00 GMT

Many retirement plans fall short of their goals because they were built on myths and misunderstandings. Most of my work at Retirement Watch falls into two categories. The first category is determining changes that should affect retirement plans. The second category is correcting the myths that have built up around retirement planning. One of the great myths of retirement planning is: Taxes will be lower in retirement. Last week we had tax return deadlines and tea parties, so this is a good time to discuss the issue of taxes in retirement, and a new survey proves a point I have made for years about retirees and taxes.

There was a time when taxes really did decline in retirement. When income tax rates were higher and there was a heavily graduated tax system, there were 13 tax brackets. Many people received less income in retirement than during their working years, and it did not take much of a drop in income to push a new retiree into a lower tax bracket. In addition, there were numerous tax breaks for seniors.

Things are different now.

We have only a few tax brackets. One needs to have a significant drop in income after retiring to drop into a lower bracket.

More importantly, retirees are making up a larger share of the taxpaying public as the Baby Boomers age. Governments cannot afford to let them pay less in taxes, and they do not.

Social Security benefits once were exempt from income taxes. For a while now, the benefits have been taxable to “upper income” recipients. The number who pay taxes on the benefits rises each year, because the income levels at which the benefits are taxed are not indexed for inflation.

Many retirees also are likely to be caught in the alternative minimum tax. Each year, more middle income retirees pay higher taxes under the AMT than under the regular income tax. That is usually because income declines after retirement but tax deductions remain the same. The combination can trigger the AMT.

In fact, unknown to many pre-retirees, taxes are likely to be your largest expense in retirement. While most people worry about medical expenses and long-term care, the biggest drain of your retirement income will be taxes. Income taxes are likely to take the largest share. There also will be sales taxes, real estate taxes, personal property taxes, and taxes on capital gains.

The new survey of retirees between ages 70½ and 75 with a net worth of at least $1 million, by Securian Financial Group, found taxes were the largest expense by a wide margin. Taxes, in fact, took about 4% of net worth every year. That is 4% of net worth, not of income. The percentage of income taken by taxes is much higher. It is tough to have net worth increase or remain stable when one expense is taking such a large portion.

Tax planning needs to be an integral part of your retirement money management. Strategies that effectively reduce taxes for many retirees include:

Tax-exempt bonds instead of taxable bonds. These won’t help reduce taxes on Social Security benefits, but they will reduce income taxes. Tax-exempt bonds carry attractive yields relative to treasury bonds now, but they also carry extra risks because of the economic distress of many state and local governments. Don’t take high risks to reduce income taxes.

Monitor the stealth taxes each year. Relatively small adjustments in income or expenses in the last part of the year might avoid higher taxes due to the itemized expense reduction, the personal and dependent exemption phaseout, and the alternative minimum tax.

Investments. Simple strategies such as minimizing trading, holding investments more than one year so the capital gains are long-term and not short-term, and buying mutual funds that traditionally make low annual distributions are easy ways to boost after-tax investment returns.

IRA management. Once distributions begin, managing the IRA is more complicated than many people realize. Taxes can be reduced and the life of a portfolio extended by withdrawing money from your different accounts in the right order and carefully calculating which assets are held in which accounts. Some retirees reduce lifetime taxes by taking money out of their IRAs faster than required under the law or converting a traditional IRA to a Roth IRA.

Maximizing deductions, such as those for charitable contributions and medical expenses, also are key to reducing taxes for many retirees.

Many retirees are surprised by the amount of taxes they pay. They believed the myth that taxes decline in retirement. The truth is without some planning taxes will stay the same or even increase during retirement. Tax breaks specifically for seniors are rare these days. Tax traps and a retirement tax ambush are more likely. You need to continue tax planning through retirement to ensure your retirement fund lasts a lifetime.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com. He also is author of numerous books and reports, including The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

IRA Inheritance Disasters: A Case Study

Bob Carlson — Fri, 10 Apr 2009 20:55:00 GMT

One point I try to emphasize regularly in my newsletter and web site is the importance of the beneficiary designation form for IRAs, pensions, annuities, and a few other assets. Yes, a will or living trust are very important to your estate plan. They do not, however, control the disposition of all your assets. Assets that avoid the probate process are not controlled by your will or trust. Only the beneficiary designation form on file with the IRA sponsor or other custodian of the assets determines who receives the assets after you.

A recent decision from the U.S. Supreme Court shows how important it is to keep your beneficiary forms up to date.

William Kennedy worked at DuPont and had a wife and daughter. He named his wife as beneficiary on the retirement plan's designation form and did not name a contingent beneficiary. Decades later, he and his wife divorced, and Mrs. Kennedy waived her rights to Mr. Kennedy's retirement benefits as part of the settlement. The waiver was not in the form of a qualified domestic relations order as defined in the tax law, which the plan would be required to follow. Since the waiver was not a QDRO, the plan documents controlled the account.

Unfortunately, Mr. Kennedy never changed his beneficiary designation form with DuPont. (He did change the designation form for another retirement plan at DuPont, naming his daughter as beneficiary.) He retired in 1998 and began receiving benefits. He died in 2001. Dupont then paid $402,000 to the former Mrs. Kennedy as beneficiary of the account.

The daughter sued DuPont, saying her father clearly intended that his ex-wife not inherit the retirement benefits. The ex-wife, she said, was compensated by other means and waived any rights to the benefits.

The Supreme Court held DuPont had no responsibility to the daughter. DuPont was bound to follow the employee's instructions on the forms filed with the employer, no matter how old and out-of-date they might seem. The ex-wife's waiver of her rights to the benefits did not amount to an assignment of the rights to the daughter. It was the employee’s job to update the forms if he changed his mind. The plan administrator is not able or required to review anything else to determine who should receive the benefits. Kennedy v. Plan Administrator for DuPont Savings and Investment Plan, US Supreme Court, Jan. 26, 2009.

The bottom line as we have said many times is your beneficiary designation forms control what happens to your retirement benefits, and you need to keep those forms up to date. This is true for retirement plans, annuities, life insurance, and other non-probate assets. You need to review the beneficiary designations at least every couple of years or when there is a major life event. Keep copies of the forms and write “superceded” or something similar on out-of-date forms, in case the custodian loses the forms. Be sure your executor knows where to find your copies of the forms.

Dos and Don'ts of IRA Investing

Bob Carlson — Fri, 03 Apr 2009 14:18:00 GMT

Many people own substantial IRAs and have the bulk of their investment portfolios in IRAs. Some of these investors might not realize there are investments that are prohibited from IRAs and others are allowed but incur tax penalties. The issue of how to invest an IRA is more important in today's climate, because "hard assets" and other nontraditional assets—those that investors prefer today—are primarily those prohibited or discouraged in IRAs.

IRA investment disincentives fall into three categories. There are prohibited investments, taxable investments or transactions, and prohibited transactions.

The prohibited IRA investments are labeled “collectibles.” When an IRA purchases a collectible, the amount used to make the purchase is treated as distribution to the owner. It is included in the owner's gross income, and if the owner is under age 59½ and does not qualify for one of the exceptions, a 10% early distribution penalty is imposed on top of the income taxes. In addition, there is a penalty each year the IRA continues to own the prohibited investment.

Collectibles are defined in the tax code as works of art, antiques, rugs, stamps, coins, metals, gems, and alcoholic beverages. The IRS is allowed to define other items as collectibles but has not done so.

Note that an IRA may purchase securities of firms that produce collectibles, such as mining companies and alcohol producers or distributors. But the IRA may not purchase the collectibles themselves.

There are other investments an IRA may own, but those investments could cause the IRA to owe income taxes on income from the investments or the owner might be taxed as though distributions were made.

An IRA is most likely to be taxed when it earns unrelated business taxable income (UBTI). The UBTI rules apply to all qualified retirement plans, not just traditional IRAs. If an IRA earns UBTI exceeding $1,000 it must pay income taxes on that income. The IRA might have to file Forms 990-T or 990-W. It also must pay estimated income taxes during the year if the UBTI exceeds $500.

The IRA owner essentially will be taxed twice on UBTI. The IRA will be taxed on the income. Subsequently, the owner or beneficiary will be taxed on distributions of that income. There is no deduction or credit available to the owner for UBTI paid by the IRA, and the tax on the IRA does not increase the tax basis of the IRA.

The UBTI rules are supposed to prevent a tax-exempt entity such as an IRA from unfairly competing with tax-paying businesses. The rules are fairly broad, however, and apply to situations in which the IRA is not operating a business. An IRA potentially has UBTI if it does any of the following:

operates a trade or business,

receives certain types of rental income,

receives certain types of passive income from a business entity it controls,

invests in a pass-through entity, such as a partnership, that conducts a business, or

uses debt to finance investments.

A "trade or business" is any activity carried on for the production of income from the sale of goods or performance of service. Any business is considered unrelated to the exempt purposes of an IRA or other retirement plan. Fortunately, the tax code specifically excludes certain types of income from the definition of trade or business income for UBTI purposes. The exempt types of income include interest, dividends, capital gains, and profits from options transactions. Royalties also are generally exempt.

Even exempt income, however, can be converted into UBTI.

Real estate rental income generally is exempt from UBTI, but becomes UBTI if the amount of rent is computed as a percentage of the tenant's profits.

Controlling a business entity also can convert exempt income into UBTI. When an IRA has greater than 50 percent control of a business entity, any rent, interest, or royalties paid by the entity to the IRA is UBTI if the payments have the effect of reducing the business income of the entity. Another way to look at this rule is that if the business entity deducts the payments to the IRA, they are UBTI to the IRA.

When an IRA owns an interest in a pass-through business entity (partnership or limited liability company), the IRA's share of the entity's income is UBTI. Pass-through entities generally do not pay federal income taxes. Instead, their income and expenses are passed through to their owners' income tax returns.

This rule most often trips up individuals who invest in master limited partnerships (MLPs) or real estate partnerships in their IRAs. MLPs are traded on major stock exchanges, and many people think of them as being the same as corporate stock. In fact, these are partnership units, and the income and expenses of the partnerships pass through to the owners at tax time. Individuals generally are urged not to purchase MLPs through IRAs.

It is not illegal to own an MLP through an IRA. The ownership, however, triggers the UBTI rules and the requirement to possibly file a version of Form 990 and pay estimated taxes. There is no tax advantage to owning MLPs through an IRA. Some tax advisors recommend taking the easier and cheaper route of reporting any IRA-owned pass through items on the individual tax return instead of filing a separate Form 990 for the IRA.

An IRA also has UBTI when debt is used to finance investments. Any type of income can become UBTI when debt is used to finance the property that generates the income. For example, if an IRA receives a margin loan from the custodian or broker, income generated by the securities purchased with the loan proceeds would be UBTI. Real estate mortgages also are debts that convert exempt income into UBTI. An IRA can own real estate and earn rental income, and that rental income will be tax deferred. If the real estate is financed with a mortgage, however, the rental income becomes UBTI.

The prohibited transaction rules are the final category of taboo investments. The rules are fairly detailed and can get complicated. Generally they prohibit transactions between the IRA and its owner or a person related to the owner (including businesses).

The penalty for violating the prohibited transaction rule is severe. The entire IRA will be considered fully distributed when the prohibited transaction was made. The IRA owner must include its full value in gross income, regardless of the amount of the prohibited transaction. If the owner has multiple IRAs, only the IRA that engaged in the prohibited transaction is penalized. Other IRAs escape the penalty unless they also engaged in prohibited transactions.

It is easy to state the prohibitions in clear, plain English: No deals are allowed involving the IRA and the owner or a person related to the IRA or its owner. Yet, there are some "prohibited transactions" allowed by IRS regulations or rulings, and IRA owners can receive waivers from the Department of Labor for specific transactions.

A detailed discussion of the prohibited transaction rules would be too much for this posting. While it is possible for an IRA to engage in transactions with the owner’s small business, real estate, or other interests, such transactions should not be considered without good tax or legal advice.

IRAs do not have complete investment freedom. IRA owners who prefer investments other than publicly-traded stocks and bonds and mutual funds need to be wary of the potential pitfalls.

Time to Stop Deferring Taxes?

Bob Carlson — Thu, 19 Mar 2009 17:34:00 GMT

Conventional investment advice has been turned on its head by changes in the fundamentals of the economy and markets. Now, fundamental changes in the government, demographics, and the economy are forcing changes in tax policy and tax planning advice.

The age-old advice is to defer taxes whenever possible and for as long as possible. Over the years, I have pointed my subscribers to a few exceptions to this strategy discovered in our research. Soon, the classic rule might become a relic. For many people, the best tax planning advice in coming years could be to pay income taxes as early as possible, because rates will be higher later.

The structural changes leading to this conclusion are significant:

We have a new President and Congress. They explicitly campaigned on promises to raise taxes, at least on the wealthiest Americans. "Wealthy" tends to be defined downward after an election, and that is likely to be the case now.

Social Security and Medicare cannot be sustained under current tax and spending policies. Either benefits must be reduced or taxes raised or both.

The policy response to the financial crisis was for the federal government to bailout, subsidize, insure, and otherwise commit to spending a lot of money. There is a chance some money will be recovered from the government's "investments," but most likely the government will have net negative cash flow.

The new government leaders plan to spend a lot more money, especially on medical care, energy, and the environment. The details are not clear at this point, but higher spending by the government clearly is part of the plan.

Environmental policy is likely to include significant tax increases.

A result of the current crisis likely will be less leverage in the economy, leading to lower economic growth. Lower growth means less tax revenue from the current tax structure and a need for higher taxes.

The President proposed a few specific tax increases in his budget plan, but others won't be known for a while. We do have a lot of clues, however, and can begin to plan.

Higher income individuals are likely to face higher income taxes. During the campaign the income cut-off for higher taxes initially was $250,000. But at times lower numbers were used, and Congress traditionally defines “high income” much lower than $250,000. The current plan is to let the 2003 tax cuts expire after 2010, which will affect many taxpayers.

All Americans are likely to be hit with indirect and non-income taxes. These include gasoline taxes, other carbon and energy taxes, and various fees and charges.

Means-testing is another likely form of tax increase. Already upper income people receive a lower return on their Social Security taxes and pay higher Medicare premiums. Benefits from Social Security and Medicare likely will be reduced above some income level. Expect similar actions in other government programs.

Tax benefit reductions also are likely in lieu of tax rate increases. Itemized deductions and personal and dependency exemptions now are reduced at higher incomes, effectively increasing tax rates. Congress likely will search for other tax breaks to phase out as income rises. Many phase outs were included in the economic stimulus law that recently was enacted. Related changes will be "closing loopholes" by eliminating deductions and income exemptions.

A long shot in the short term is imposition of a value added tax or some kind of a national sales tax. This tax can be hidden in the cost of goods and services, raised easily, and will generate a lot of money for the government.

Taxes on long-term capital gains are likely to rise above their current 15% level. A rise to 20% seems almost certain after 2010, and an increase to 28% is possible. Taxes on dividends also will rise. The question is whether they will be taxed the same as long-term capital gains or will return to being taxed as ordinary income.

The bottom line is reduced benefits, higher taxes, and fewer opportunities to reduce taxes. Most people should plan to spend less, save more, and work longer.

A good guess is that most over age 55 won't have to deal with lower benefits from Social Security and Medicare, except those with higher incomes. Those farther from retirement likely will face changes.

What should you do?

The good news is the economic crisis prevents the imposition of higher taxes for a year or more. That gives you time to plan.

IRAs and retirement accounts likely will be hurt by future tax increases. All distributions are ordinary income, and you cannot spend the money without taking a distribution.

In the past I showed subscribers when it makes sense to pay taxes early on an IRA by either emptying it or converting to a Roth IRA (if adjusted gross income is $100,000 or less). These strategies will be profitable now for more people if income tax rates rise. In 2010 and later years under current law anyone will be able to convert a traditional IRA to a Roth IRA.

More people should give serious thought to emptying their IRAs early or converting to Roth IRAs. Details are in the members section of my web site and in my book The New Rules of Retirement.

It is too soon to sell appreciated capital assets to avoid higher taxes. A retroactive capital gains tax increase is unlikely. The government wants to tell investors in advance that the tax will increase, because the announcement will trigger asset sales by people seeking to lock in the lower rate, boosting government revenue. Be ready to sell appreciated assets in a year or two to avoid higher capital gains taxes, and expect lower after-tax returns from capital assets after that.

The same advice applies to dividends. There won't be much you can do to avoid the eventual increase. Factor lower after-tax income from dividends in your plans. As the tax rate on dividends increases higher after-tax income might be available from bonds or other income investments.

Reconsider plans to defer future income. Your income tax rate in the future is likely to be higher than today. You could have more money in the long-term by paying taxes today and investing the after-tax amount.

That means you should review IRA and 401(k) contributions and deferred compensation arrangements. Those earning $50,000 or less probably won't be hit with higher income tax rates and can safely continue tax deferrals. But the higher your income is above $50,000, the greater your risk of paying higher rates in the future. Income tax rate increases might very well be retroactive at some point. In a rising income tax regime, it is better to pay taxes today than in the future.

Forget the notion you will be in a lower tax bracket in retirement. Many of us will be in higher tax brackets, especially when all types of taxes are included. This is another reason to reduce tax deferral.

Retirement spending plans should be revised to reflect higher costs. If you are not already retired, consider working longer and saving more. You might have to pay more for medical care, utilities and other energy-using services, and more. Your Social Security benefits might be reduced because of means-testing. As the tax proposals become more specific and are closer to enactment, investment plans will need to be revised or you will have to accept lower after-tax returns.

Bob Carlson is editor of the monthly newsletter and web site Retirement Watch (www.RetirementWatch.com). He also is the author of The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

2009 a Key Year for Roth IRA Conversions

Bob Carlson — Fri, 09 Jan 2009 20:05:00 GMT

Converting a traditional IRA to a Roth IRA has been a valuable tool to consider since the Roth was created in 1997. There are two reasons why a conversion is worth far more consideration now than in the past.

First, a brief review of the basics. A Roth IRA has "back-ended tax benefits." There are no deductions for contributions. Like a traditional IRA, earnings are not taxed while they remain in the account. The big benefit is that qualified distributions from the Roth IRA are tax free. A qualified distribution is one that occurs on the later of when the owner turned age 59½ and five years after the owner opened any Roth IRA. The distributions are tax free whether made to the original owner or to a beneficiary who inherits the Roth IRA.

Another benefit of the Roth IRA is there are no required minimum distributions imposed on the owner. The owner does not have to take money out of the IRA unless he needs it. The Roth can compound undisturbed and be left to the next generation if desired. Beneficiaries are required to take minimum distributions based on their life expectancies.

There are a few other benefits of the Roth IRA. Distributions are not included in gross income when determining the amount of Social Security benefits to be taxed. In addition, when nonqualified distributions are taken, contributions are considered to be withdrawn before accumulated income and gains. That means money can be withdrawn tax free if needed, and no taxes are due until all the contributions have been withdrawn.

A Roth IRA can provide higher retirement benefits than a traditional IRA if the tax-free compounding is allowed to work for years. With the traditional IRA, the price of deducting contributions ("front loaded tax benefits") is distributions are taxed as ordinary income. That means long-term capital gains are converted into ordinary income.

Investors with traditional IRAs may convert them to Roth IRAs if adjusted gross income is no more than $100,000. The AGI limit applies regardless of filing status. A married couple filing jointly with a joint AGI above $100,000 cannot convert, even if each would be eligible separately to convert. The AGI limit for marrieds filing separately is $0, so couples cannot become eligible by filing separate returns. Any required minimum distribution for the year does not count toward the $100,000 limit.

The price for converting a traditional IRA to a Roth IRA is to treat the converted amount as though it had been distributed. The amount is included in gross income.

We discussed conversions in some detail in past visits, and those discussions are in the Archive on the web site. Our research points to several conclusions about converting a traditional IRA to a Roth IRA:

A conversion can make sense if the Roth IRA will be allowed to compound for years before distributions begin. If a 6% rate of return is expected, it takes about 10 years of compounding to make up for paying the taxes.

The income taxes should be paid from separate assets instead of from the IRA. You want the full IRA balance to benefit from the tax-deferred compounding and eventual tax-free distributions. Otherwise it takes learn for the conversion to pay off.

The higher the rate of return of Roth IRA, the faster you reach the pay-off from the conversion. You don't want to convert a traditional IRA to a Roth IRA and invest the Roth IRA in certificates of deposit or short-term bonds.

All or part of an IRA can be converted, and there is no limit to the dollar amount that can be converted in a year. If you own more than one IRA, they can be converted in any combination you want: all of one, portions of more than one, or even all of each of them.

A nice feature of the Roth IRA conversion is that you get to reverse it if it turned out to be a bad idea. We will discuss that shortly.

One of the factors that should make a conversion to Roth IRA worth serious consideration is the bear market in investment assets across the board.

Remember the conversion tax is imposed by including the converted amount in gross income. The lower the value of the IRA on the date of conversion, the lower the tax will be. The bear market has decreased the value of many IRAs to their lowest levels in years. You can convert a traditional IRA to a Roth IRA at a much lower cost than in the past.

The benefit of converting a Roth IRA at a low level is that the future appreciation and income will be tax free. As the IRA recovers from the bear market, the value that would have been taxed as ordinary income before the bear market will be tax free after the conversion and recovery.

Converting to a Roth IRA can be an important move in restoring your retirement fund. Take the example of Max Profits, who had a balance of $500,000 in his IRA at its peak. Recently it was worth $250,000. At the peak, Max's IRA had an after-tax value of only $325,000 in the 35% tax bracket. Converting to a Roth now would cost $87,500 in taxes (compared to $175,000 at the peak). After the Roth IRA is converted and returns to its future value, the after-tax value is $500,000.

The trade off in a conversion is that you lose the money used to pay the taxes and future after-tax earnings on that money. As I said, my analysis over the years has shown that someone who expects to earn a return of 6% needs about 10 years of compounding to break even. But the forecast changes based on a number of key assumptions, including your current and future tax rates, the rates of return on the IRA and non-IRA assets, and the amount of time before distributions begin.

The calculations can be complex, and there are a number of web sites with calculators to help you. The quality of the calculators differs, because not all allow you to vary each of the assumptions. Most mutual funds and brokers have calculators on their sites. A good calculator also can be found at www.rothira.com. A few other calculators with no ties to financial products or services are at www.datachimp.com, www.voli-tion.com, www.dinkytown.com, and www.cust-omcalculators.com. (Ignore the hyphens.) Financial planners of course can do calculations for you.

Another reason to consider converting now is that income taxes are likely to rise in the future. Most political observers expect taxes to increase, and the President-elect and the majority in Congress advocated higher taxes on at least some taxpayers. If you have enough time to compound returns to make up for paying taxes early, why not pay taxes at today's lower rates? Doing so shortens the pay off period.

The conversion to a Roth IRA essentially is risk free, because if circumstances change or there is a mistake in your assumptions, you can reverse the conversion, known as a recharacterization.

The two most common reasons to reverse a conversion are that the portfolio continued to decline in value and that AGI income exceeded the $100,000 limit. Some people also recharac-terize when the conversion pushes them into a higher tax bracket or when they no longer have cash to pay the conversion taxes.

A recharacterization can be done any time before the due date of the tax return for the year of the conversion, including extensions. The extension date can be used for the recharacterization even if the taxpayer filed the return by April 15. For example, if an IRA is converted in 2009, the recharacterization can occur any time up to Oct. 15, 2010, regardless of when the 2009 return is filed.

After a recharacterization, it is possible to convert to a Roth IRA again. The second conversion cannot occur in the same calendar year as the first. The second conversion also cannot occur within 30 days after the recharacterization.

Higher income individuals will have a chance to convert their traditional IRAs to Roth IRAs in 2010 and later years, unless the law changes. All taxpayers who convert in 2010 will have the opportunity to defer taxes on the conversion, again unless the law changes. Details about the opportunities in 2010 were in our March 2008 visit, which is available in the web site Archive.

IRA owners with AGI of $100,000 or less must consider whether to convert their IRAs in 2009 or 2010. The benefit of a conversion in 2010 would be the ability to defer taxes on the conversion interest free. The larger benefit, however, is likely to come from converting the IRA at a low value. Watch your portfolio. If it remains stagnant or in a trading range through 2009 as I expect, waiting until 2010 to convert is worthwhile. But if a new bull market seems underway, convert before it goes too far. The tax savings from a low conversion value are more valuable than deferral in 2010 at a higher value.

More details about conversions to Roth IRAs are in my book, The New Rules of Retirement, and are in the member’s-only section of my web site Archive at www.RetirementWatch.com.

A Tricky Year-End for IRA Owners

Bob Carlson — Fri, 05 Dec 2008 14:15:00 GMT

Update Dec. 19: On Dec. 11 Congress passed legislation that suspended the required minimum distribution requirement for 2009. But it did not change the requirement for 2008. the IRS was asked by members of Congress to suspend the requirement for 2008. But on Dec. 17 it sent a letter to key members of Congress saying it would not do so. An IRS official told the Washington Post that it did not have authority to change the rules. Only Congress could do that. In addition, the IRS could not devise a solution that would be fair to those who took their 2008 RMDs before December.

The financial crisis continues to have secondary effects few people anticipated. Decisions are required now, especially with regard to IRAs. Let's take a look at the key issues in question-and-answer format.

Is there relief for IRA owners over age 70½ who have not yet taken their required minimum distributions for the year?

IRA owners must take required minimum distributions by April 1 off the year after they turn age 70½ and by Dec. 31 of each year after they turn age 70½. The RMD is computed based on the IRA balance as of Dec. 31 of the preceding year. The Dec. 31, 2007, balance is used to determine the 2008 RMD. We discussed details of computing the RMD in the April 2008 visit, and that discussion is available on the web site Archive.

The problem for 2008 is that many IRA balances are far below their 2007 levels. Major stock market indexes are down around 35% to 40% from that date. Some investments declined even more. IRA owners who have not already taken their RMDs for the year are required to take RMDs on wealth that no longer exists.

There is only one limited provision in the tax law to reduce the RMD in this circumstance. The RMD is fulfilled when the amount taken from the IRA brings the balance to zero. That does not help many IRA owners. If taking the RMD does not wipe out all your IRAs, you are required to take the full RMD as calculated using the 2007 balance.

Several proposals were put forth in Congress in 2008 to provide some way of altering the requirement for those whose IRAs declined. None was enacted, but there is a possibility of some action in a special session now taking place. If there is a bailout bill for the auto companies there is a chance a waiver for RMDs will be included. But that is not very helpful, since you have to take your distribution by Dec. 31, and IRA sponsors often get backed up this time of year. If you wait to put your RMD order in, it might not be processed by Dec. 31. IRA owners are in a tough spot on this issue, because waiting to see if Congress acts could mean a distribution won’t be made by the Dec. 31 deadline if Congress does not act.

Can the RMD be avoided by converting the traditional IRA to a Roth IRA?

The original owner of a Roth IRA does not have to take RMDs (though beneficiaries who inherit Roth IRAs do). A traditional IRA can be converted to a Roth IRA when the owner's adjusted gross income is no more than $100,000. There are taxes due on the conversion. The converted amount must be included in gross income as though it were distributed. The converted amount and any RMD for the year do not count in determining the $100,000 limit.

This is a good time to convert a traditional IRA to a Roth IRA, because asset values have declined. You can make the conversion at a much lower cost than a year ago, and the future income and gains will be distributed tax free to you and the IRA beneficiary.

A conversion, however, cannot be used to avoid a current required minimum distribution. If the IRA owner is required to take an RMD for the year, the RMD still must be taken even if there is a conversion and regardless of the date during the year the conversion occurred. The conversion, however, will avoid future RMDs.

If I have to take an RMD this year, which assets should I sell to take it?

A common misconception about RMDs is that an asset has to be sold and then the cash distributed from the IRA. In fact, a distribution of either cash or property meets the requirement, as long as the value of the property on the day of the distribution equals the RMD for the year. Or if several distributions are taken over the year to fulfill the RMD, the aggregate of the property values on the dates of their distributions must at least equal the RMD. You don’t have to sell any assets to take an RMD.

Most IRA custodians also offer taxable accounts. It is a simple procedure to set up a taxable account at the custodian. Then, direct the custodian to transfer property from the IRA at least equal in value to the RMD to the taxable account. The transferred property can be bonds, shares of stock or mutual funds, other securities, or any other property in the IRA. The custodian will determine if some of the property is not transferable.

If the custodian does not offer taxable accounts, set up a taxable account at another financial institution that will accept the assets. Then, have the securities or other assets transferred from the IRA to the new taxable account. This transfer might take more time, so the paperwork has to be started earlier in order to meet the Dec. 31 requirement.

If you do not want to sell assets to fulfill the RMD, you do not have to. Instead, distribute property from the IRA to a taxable account. The value of the property at the time of the distribution will be included in gross income and count as the RMD. The tax basis of the assets will be their value on the date of distribution, the same amount included in gross income. Because of the tax treatment, it makes sense to distribute those assets that have declined the most and are likely to appreciate the most in the future. Once those assets are in a taxable account, future appreciation is likely to be taxed as long-term capital gains. If the assets remained in the IRA, future appreciation would be taxed as ordinary income when distributed. Also, if the assets continue to decline in value after being distributed, the assets can be sold and the loss deducted on the tax return. Losses in an IRA cannot be deducted in most cases.

I need at least part of the RMD in cash to pay expenses. How should I determine which assets to sell and distribute? Those that have declined the most, the least, or some other measure?

One step investors fail to take on a regular basis is to rebalance their portfolios. A portfolio should have a target asset allocation that meets your return goals and risk tolerance. Over time the markets move the portfolio out of balance because the investments will have different rates of return. The portfolio should be rebalanced to bring it back to its original allocation target.

RMDs can be used to rebalance the portfolio. Sell or take distributions of assets in ratios that bring the portfolio to its target allocation. Sell assets that are above or closest to their targets. That is the fastest way to bring the portfolio back to target. Other changes can be made within the IRA to bring it back to your target allocation, such as selling those that have declined the least to buy more of those that are farthest from their targets. You can choose to make sales and distributions in other ways, but recognize that those would be a change in your portfolio strategy.

Another approach is to use tactical asset allocation to choose the RMD assets. For example, you might choose to hold the assets that have held their value best. Or you might hold those that have declined the most, believing they are likely to appreciate the most when things turn around. Either move would be a bet on coming market trends. The first strategy would be an assumption that recent trends will continue. The second move would be based on a belief that we are near a bottom and you want to capture the following rally. There is nothing wrong with either move. Be aware that you would be straying from your initial strategy and effectively making a forecast about the market.

I sold an asset in my IRA to take a distribution. Can I buy that same asset in my taxable account?

This question is a reference to the "wash sale" rules which prevent a taxpayer from selling an asset to deduct a loss but immediately buying the same asset so that the portfolio position has not changed. The wash sale rules say that a loss deduction is deferred if a substantially identical asset is purchased within 30 days before or after the sale. The wash sale rules apply whether the substantially identical asset is purchased in an IRA or taxable account.

Since a loss incurred in an IRA is not deductible, however, the wash sale rules do not discourage or prohibit you from purchasing a substantially identical asset in a taxable account after selling it in an IRA.

What are the rules for making charitable donations directly from an IRA?

For most people, there is no good reason to make a charitable contribution from an IRA. If you do, the amount is treated as a distribution and included in gross income. You can take a charitable contribution deduction for the identical amount. But you must itemize deductions on Schedule A to benefit. In addition, if your income is high enough, the itemized deduction reduction reduces the amount of your charitable contribution. So, you might not have a full offset of the amount included in gross income.

Those who are over age 70½ receive special treatment. This provision was in effect for 2007 only but recently was extended to the end of 2009.

The special treatment is that a charitable contribution can be made directly from the IRA without including it in gross income. There is no offsetting deduction, but there is no gross income either. Only the first $100,000 of charitable contributions from IRAs each year receives this treatment. In addition, the contribution must be made directly from the IRA to the charity. You must direct the IRA custodian to make the transfer or issue a check.

Another bonus is that the donation can count as part of your RMD for the year. You still are required to take the full amount of the RMD based on the 2007 balance. But by giving all or part of the RMD to charity, the amount does not have to be included in gross income.

Your Retirement Plan and the New Washington

Bob Carlson — Fri, 07 Nov 2008 17:44:00 GMT

Come January, Democrats will be in charge all over Washington. They campaigned on a theme of change, and we should expect major changes. The questions are which changes and how will they affect your retirement finances?

I will focus on the changes I think are most likely to occur. When evaluating the prospects for change, it is important to keep in mind the tension that will exist in the New Washington. Congress will be run by very liberal politicians who have a long list of legislation they wanted to pass for many years. These wish lists generally involve higher spending, more government control and regulation, rewarding favored activities and punishing others, and of course higher taxes. The new President, on the other hand, wants to be re-elected and probably recognizes that the country is center-right, not liberal, on most issues. There will be tension between the President and Congress, and the great unknown is which one will prevail. I assume that for at least the first couple of years the President will have the upper hand and will be able to move the more extreme liberal measures to the back burner.

Here are things you should prepare for over the next year or two. Other changes might be coming after that.

Medicare: This health program for those over 65 is approaching bankruptcy. Social Security will begin spending more than it receives in a few years. Medicare passed that point long ago. It soon will have exhausted the “trust fund” set up for it and rapidly is taking a larger share of the federal budget.

A few years ago “means-tested” premiums began as we discussed in Retirement Watch. Premiums increase as a beneficiary’s income rises. Similar changes are likely to occur. Premiums for higher income beneficiaries could rise even more and some types of care might not be covered for higher income beneficiaries. Or deductibles and co-payments also might be means-tested. Higher income beneficiaries might be required to cover the first $5,000 to $10,000 of their medical expenses in addition to paying higher premiums.

The government might have a stronger role in “negotiating” drug prices. Medicare prices are a basis for prices providers charge to private insurers. If the government negotiates very low prices, manufacturers might conclude that some drugs are unprofitable to produce or reduce research spending on new drugs.

The government also might take over the Part D prescription drug program instead of allowing private insurers to compete for beneficiaries.

Medicare Advantage plans also might take a hit. Democrats in Congress have targeted these since returning to the majority after the 2006 election. These plans run by private insurers receive higher reimbursements than other Medicare plans but usually offer greater benefits. Democrats want to eliminate them and bring everyone back into traditional Medicare.

Greater use of technology is likely to be mandated across the medical profession, and the government will assume cost savings from this move. It also is a way of pushing costs from the government to the private sector. That could affect the quality or availability of care for a while and increase costs on care not covered by Medicare.

Estate tax: Congress has to address the estate tax soon. The current law eliminates the estate tax for 2010 and returns to the 2001 law beginning in 2011. Congress is unlikely to let either the expiration or return to 2001 law occur.

The most likely outcome is, after a great deal of debate, something similar to current law will be enacted. That means the estate tax exemption will be fixed at $3.5 million and might be indexed for inflation. The top estate and gift tax rate will be 45% or 46%, though it could go up to 50%. It will be interesting to see if the lifetime gift tax exemption remains capped at $1 million or is allowed to rise. Also unclear is whether the current step-up in basis that is allowed for inherited assets will continue or whether heirs will have to take the deceased’s basis and pay capital gains taxes on appreciated that occurred during the deceased’s ownership.

Retirement plans: Here is a sleeper issue that came up only in the last month. Many in Congress do not like President Bush’s “ownership society” concept, and they view 401(k) plans as part of that. They are looking at ways to change qualified retirement plans.

A longstanding goal was to require private employers to provide minimum pensions. That might be replaced by a plan to have the government take over private pensions. Recent committee hearings highlighted a plan that eventually would eliminate tax breaks for 401(k) plans and give individuals a window during which they would receive some benefits for converting their private 401(k) plans into government retirement plans. This approach clearly has support from congressional leaders, but its support beyond that is unclear.

Investing: Anticipate some surprises here. Presidents are not able to implement all their campaign proposals. Congress and circumstances can change the plans. Don’t invest based on campaign rhetoric. Wait until proposals are closer to becoming laws.

There could be a positive surprise in the change of power. The financial problems largely have developed into a confidence problem. People do not trust current leadership or the information it puts out. Financial companies do not know what to expect from the government, so they are hoarding cash to protect themselves. Investors simply are not buying anything with risk, and financial firms are not doing business.

Some shrewd moves by the new President in the next few weeks could start to restore confidence at least temporarily. Appointment of a popular choice for Treasury Secretary and announcement of an effective tax cut and regulatory reform plan could spur optimism among investors.

Of course, stumbles on any or all of these issues could extend the crisis. Further down the road, higher taxes, spending, and regulation could reverse any positive trends. But there is an opportunity now to restore optimism even as the economic slump deepens for the next quarter or so.

Congress also could squander the opportunity. There is a movement to expand the government rescue plan to include a range of industries and to impose very tight regulations on financial and other firms taking government money that effectively nationalizes them. A move in that direction would further diminish investor confidence.

Don’t believe simple analyses of how the new administration will affect investments. It is normal for analysts to look at campaign proposals and target companies they believe will benefit from the proposals. Those forecasts almost never work out. Ignore analysts who recommend that you buy “green companies” and short defense contractors and health care companies. Wait for detailed plans to be proposed and make their way through Congress.

Taking action simply on the new election of politicians can be a risky business. I have outlined what I think are the most likely changes over the next few years. But be prepared for surprises. You need to build a cash cushion in your retirement plan for the possibility of paying a higher share of medical expenses. Be ready to revise your estate plan sometime next year or early in 2010. Keep an eye out for early signs of changes in retirement plans and be ready to move your assets into other types of accounts in case a major change is in the works. With your portfolio, don’t fall for obvious analysis. There is the potential for surprise in the next few weeks.

Maximizing the New Roth IRA Opportunity

Bob Carlson — Fri, 17 Oct 2008 22:05:00 GMT

The markets created an opportunity for investors to convert traditional IRAs to Roth IRAs. The opportunity will last only as long as the financial crisis lasts and markets are bearish. Investors who converted their IRAs into Roths earlier this year probably should reverse them and consider converting again next year.

The benefits of a Roth IRA are well known. There are no front-end benefits such as a deduction for contributions. Only after-tax money can be contributed to a Roth IRA. But earnings compound tax-free within the Roth IRA. In addition, qualified distributions from the Roth are tax free. A qualified distribution is one that is taken the later of five years after the Roth is opened and after age 59½. In addition, the original owner of a Roth IRA is not required to take required minimum distributions after age 70½, though beneficiaries who inherit Roth IRAs are required to take RMDs after inheriting them.

A traditional IRA can be converted into a Roth IRA. In 2008 and 2009, the IRA owner must have adjusted gross income under $100,000. (Those with higher AGIs will be able to convert in 2010 and later years.) In addition, the owner must pay a conversion tax on the converted amount. The amount converted is included in gross income as though it were distributed. There is no 10% early distribution penalty on the converted amount if the owner is under age 59½.

This is a good time to consider converting, because the bear markets in 2008 drove down the value of most IRAs. A traditional IRA can be converted into a Roth IRA at a much lower cost than a few months ago and probably at a lower cost than sometime in 2009 after the markets recover.

Converting a traditional IRA to a Roth IRA is not for everyone. When does it make sense to convert a traditional IRA to a Roth IRA? There are several factors to consider.

§ How will taxes on the conversion be paid? The conversion is more valuable and passes the break-even point faster if the taxes are paid from non-IRA accounts so that the entire IRA is converted and begins compounding. If part of the IRA must be distributed and used to pay taxes, it takes longer for the conversion to pay off. In addition, if the owner is under age 59½ and uses a distribution from the IRA to pay the conversion taxes.

Because assets outside the IRA should be used to pay the taxes, it might make sense to convert an IRA over a period of years. Determine how much cash is available outside the IRA to pay income taxes this year, and convert the appropriate amount of the IRA for that level of taxes. More of the IRA can be converted in later years as cash is available to pay the taxes.

§ How long will the Roth IRA be left to compound before distributions begin? The goal in making the conversion is to have more after-tax wealth in the long-term. To accomplish that the converted amount must be allowed to compound its income and gains to make up for the taxes that were paid. If conversion taxes are paid from a taxable account and the IRA earns at least 8% annually, it takes at least seven years of compounding to reach the break even point. A longer compounding period generates more after-tax wealth for the owner than keeping the traditional IRA would have. A lower rate of return means a longer compounding period is needed to break even.

§ Will the tax rate be different when distributions begin? If the tax rate will be lower than in retirement than it is today, it might not make sense to pay taxes at today's rate unless there is a substantial compounding period. But if you anticipate higher tax rates in retirement, converting at today’s tax rate is profitable.

§ Will future Social Security benefits be taxable? If the taxpayer estimates having a high enough retirement income for benefits to be taxed, a conversion could reduce those future taxes. The Roth distributions are not included in gross income under current law while traditional IRA distributions are. If IRA distributions will be a big part of retirement income, shifting them to a Roth could save the Social Security benefits from taxes.

§ Will required minimum distributions from the traditional IRA exceed spending needs? When an owner has a large IRA and enough assets outside the IRA to meet living expenses, it might make sense to empty the IRA early. This is discussed in more detail in my book, The New Rules of Retirement. The RMDs force unneeded distributions and increase income taxes for both you and eventually your heirs.

An alternative to emptying the IRA early is to convert the IRA to a Roth IRA. This is not possible for many owners of large IRAs because of the $100,000 income limit, but it will be possible in 2010 when the income limit is removed.

§ What will state income taxes be? Not all states exempt Roth IRA distributions from income taxes. This should be checked before a conversion is undertaken.

Many mutual funds and other financial services firms have calculators on their web sites to help determine if converting to a Roth IRA will increase after-tax wealth. A good calculator also can be found at www.rothira.com. A few other calculators with no ties to financial products or services are at www.datachimp.com, www.volition.com, www.dinkytown.com, and www.customcalculators.com. Financial planners of course can provide calculations.

IRA owners should consider each year whether a conversion would be profitable. After a conversion is done, the IRA and tax situation should be monitored. The owner might want to reverse the conversion. Those who converted traditional IRAs to Roth IRAs earlier this year should consider reversing the conversion, known as a recharacterization. You would want to recharacterize the IRA because the conversion taxes are paid on the value of the IRA at the date of conversion. You will be paying taxes in April on a value that no longer exists.

The conversion can be reversed any time before the due date for the tax return for the year of the conversion, including extensions. The extension date can be used even if the taxpayer files the return by April 15. This means if you converted an IRA in 2008, the recharacterization can occur any time up to Oct. 15, 2009, regardless of when the 2008 return is filed. If the return was filed and taxes on the conversion paid, an amended return can be filed to get a refund of the conversion taxes.

Once recharacterized, the IRA can be left as a traditional IRA, or in the future it again can be converted to a Roth. The second conversion cannot be made in the same year as the original conversion. A second conversion also cannot occur until more than 30 days have passed since the recharacterization.

There are a couple of times when a taxpayer might want to reverse a conversion.

One reason to recharacterize is that income for the year (excluding the converted amount) unexpectedly exceeds $100,000. A conversion is not allowed when modified adjusted gross income is more than $100,000. When income exceeds $100,000 a taxpayer who wants the benefits of a Roth IRA has to recharacterize and wait for another year when the $100,000 threshold isn’t breached.

The other reason to recharacterize as we said is that the value of the IRA declined after the conversion.

Before beginning a conversion plan, check the fees charged by your IRA custodian. Some will charge for each conversion and recharacterization. Also, be sure the custodian does not impose restrictions in addition to those of the IRS. If your custodian could impede your plan, switch custodians. Another point: IRA custodians often are backed up with requests near the end of the year and cannot process them all promptly. Some transactions IRA owners want done by Dec. 31 are not completed because of the back log. Make your decision and process your paperwork early.

Avoiding IRA Inheritance Disasters

Bob Carlson — Fri, 19 Sep 2008 17:31:00 GMT

IRAs are supposed to be simple, but when it comes to inheritance IRAs are more complicated than most people realize. It is not unusual for IRA heirs to misunderstand some key rules. A wrong move or two triggers high taxes, often causing most of the IRA to end up with the IRS. Income taxes can take 35% or more of the IRA. Estate taxes can take another chunk.

Part of your estate planning should ensure that your heirs know what to do — and what not to do — with the IRA. Don't expect that they will get good advice from the IRA custodian, or just any accountant, or financial professional. We are in the early stages of the first generation to inherit IRAs, and many advisors are not up to speed on the rules. IRA custodians are not in the business of advising beneficiaries or their best moves. You need to get good advice and pass it on to your heirs.

Here are the key inherited IRA mistakes and how to avoid them.

Disappearing documents. Your will or living trust has no effect on an IRA. Only the beneficiary designation on the form held by the IRA custodian determines who inherits the IRA. IRA owners often make the mistake of not designating a beneficiary or not updating the form after a beneficiary passes away. Another common mistake is the heirs’ misplacing or not being able to find the designation form. They have to depend on the custodian to have a current copy. Custodians don’t always have a copy, especially if it was filed many years ago or the original firm has merged one or more times.

In any of those cases, the custodian's rules (if it has any) determine the beneficiary. It might be your estate, which is the worst result from a tax standpoint. Or it might be a spouse when you intended the IRA to go to your children.

Keep copies of your beneficiary designation forms in a file that is easy to find, and keep the designations up to date. Let your executor and heirs know where the forms are.

Ignoring spousal benefits. When a surviving spouse inherits an IRA, a special option is allowed.

One option is for the inheriting spouse to treat the IRA the same as any other beneficiary can. Or the spouse can roll over the inherited IRA into a new IRA in his or her own name. The rollover allows the surviving spouse to start a new required minimum distribution schedule based on his or her own age. It also allows the spouse to name new beneficiaries.

The rollover often allows the IRA to last longer both during the spouse's lifetime and when his or her beneficiaries inherit the IRA. Without the rollover, required distributions must begin soon after the IRA is inherited and might use a shorter distribution schedule than the spouse could establish under a rollover.

If the inheriting spouse is under age 59½, however, and needs to begin taking withdrawals from the IRA, then a rollover would not be a good idea. Distributions before age 59½ would be subject to a 10% penalty in addition to income taxes. But the 10% penalty does not apply when the RMDs come from an inherited IRA that is not rolled over.

Your spouse should know that he or she has options, and the consequences can be very different. Ensure that a good advisor is available to your spouse or leave some suggestions and guidelines for the spouse to follow.

Rolling over an IRA or changing the title. Non-spouse beneficiaries don't have the same options as surviving spouses. For example, if your children inherit the IRA and roll it over into their own IRAs, then the entire inherited IRA would be fully taxable. The children would be treated as though the inherited IRA were distributed directly to them in cash. They might also owe a 6% excess contribution penalty for each year the money sits in their IRAs. If they roll over the inherited IRA to new, separate IRAs in their own names, they will owe only the income taxes.

Yet, many IRA custodians simply ask the heirs what they want to do with the IRA and don’t explain fully the consequences of the actions.

To prevent immediate taxation, an inherited IRA must be maintained, but it must be retitled by Sept. 30 of the year after the year of the original owner's death. The new title must have the name of the deceased followed by "deceased" or "decedent." Also included must be the beneficiary’s name and statements that the account is "for the benefit of" or "FBO" of the beneficiary and that it still is an IRA. For example: Max Profits, deceased, IRA FBO Hi Profits, beneficiary.

Spending down the IRA. Despite all their parents' planning, an extremely high percentage of nonspouses who inherit IRAs take the balances as lump sums and spend them. That's too bad. The heirs will pay income taxes on the entire balances. The amount they have left to spend depends on their income tax brackets and your estate tax bracket. In most cases, it is a fraction of the IRA’s original value.

Instead of spending the IRA on whatever their current needs are, heirs should let the IRA continue to compound tax deferred. They would end up with significantly more wealth than they would by taking a distribution. It probably even makes sense for the heirs to suspend their own 401(k) and IRA contributions or other savings to free their own cash instead of taking distributions from the IRA.

If your beneficiaries are likely to spend the entire IRA after inheriting, consider leaving them other property if you have it. It would be better to leave the IRA to other beneficiaries or charity. Heirs that plan to spend the inheritance quickly are better off receiving non-IRA assets, if that option is available to you.

Inheritors of IRAs who do not spend the balance right away must begin taking required minimum distributions over their life expectancies. The RMDs have to begin by Dec. 31 of the year following the year of the previous owner's death.

Some heirs fail to begin taking the RMDs, so they pay penalties. Others take the RMDs under the wrong schedule and take larger distributions than they need to. Be sure your heirs who will not spend the IRAs have good information about how to determine the RMDs that will stretch the IRA the most.

Overlooking the tax deduction. Distributions from an inherited IRA are what the tax code calls income in respect of a decedent. This status entitles the recipient to an income tax deduction for the portion of the estate tax attributable to the IRA. Determining the deduction can be complicated. First, determine the amount of the estate tax paid that is attributable to the IRA. Then, the duration of the IRA distributions is estimated. Finally, a pro rata portion of the tax is deducted each year that a distribution is taken. Details are in IRS Publication 3920.

Not splitting the IRA. Until 2001 and 2002 changes, when multiple beneficiaries inherited an IRA most of the time they had to share the IRA. That meant making joint investment decisions and computing required distributions based on the age of the oldest beneficiary.

Now, an inherited IRA can be split into separate IRAs for each of the beneficiaries. Then, each beneficiary makes individual investment decisions and takes required distributions based on his or her own life expectancy.

If splitting an IRA is what your heirs are likely to do, then check with your IRA custodian. Though the tax law allows IRAs to be split, the custodian doesn’t have to allow it. Be sure the custodian will allow a split and will not charge fees or penalties for the split. If it won’t, move the IRA to another custodian now.

Also, be sure your heirs know their options, the consequences, and the deadlines.

IRAs are the prime assets in many estates. They are surprisingly complicated financial accounts — especially when it is time to take distributions. Few people know how to handle them. Be sure your beneficiaries have the information they need to make the right decisions.

Reducing the Mortgage on Your IRA

Bob Carlson — Thu, 07 Aug 2008 15:45:00 GMT

Most people are busy accumulating large balances in their IRAs and 401(k)s and managing the accounts. They forget that the IRS holds a mortgage on those accounts. You put mostly pre-tax dollars in the accounts and let income and gains compound tax deferred. But that balance in the IRA is not all yours. The price for those tax breaks is that all distributions (other than after-tax distributions) are taxed as ordinary income during retirement.

The tax burden can be viewed as a mortgage that the IRS holds on your IRA. It lent you the tax money with the deferrals during the accumulation years. When the distribution years come, the IRS wants that loan repaid. It will take a piece of each distribution. If your state has an income tax, it made the same loan and also wants to be repaid from distributions. At current rates, the IRS could take up to 35% of your IRA, and your state could take an additional share. Many people will lose about a quarter to two thirds of their IRAs to income taxes. The after-tax balance of their IRAs is 75% to 66% of the current value.

Fortunately, the IRS’ mortgage on your IRA is not a fixed rate. There are strategies that can reduce the amount of the IRA mortgage that has to be repaid. Think of these as ways to refinance your IRA. The more wealth you have both in and out of the IRA, the more flexibility you have and the bigger the pay off from reducing the mortgage. Consider these strategies and choose one or more that fit your situation and allow you to slash the IRA mortgage.

Charitable gifts. Many people make charitable gifts from their estates. Unfortunately, many of these gifts are made with non-IRA assets. A better route for those with substantial IRAs might be to make charitable gifts from their IRAs.

When heirs inherit an IRA, the IRA is included in the estate of the owner and possibly subjected to estate taxes. Then, each distribution the heirs take is taxed as ordinary income to them. The heirs often don't end up with much of the IRA after taxes.

If a charity is beneficiary of the IRA, there are no estate taxes, and the charity pays no income taxes on distributions to it. The heirs can inherit other assets held outside qualified retirement accounts. They get to increase the tax basis of the assets to their current fair market value. The assets could be sold immediately with no income or capital gains taxes (though there still might be estate taxes on them).

When there is a choice, it often is best to make charitable gifts in an estate through IRAs and leave other assets to heirs. (Currently, there is no benefit to making lifetime charitable gifts using an IRA. You have to take a distribution, include it in gross income, and take a deduction for the gift. But there are proposals in Congress to change this.)

Roth conversion. Converting a traditional IRAs to Roth IRAs can be a good way to reduce the mortgage on an IRA.

A traditional IRA can be converted to a Roth IRA when the owner's adjusted gross income is no more than $100,000 for the year. (The income limit is lifted in 2010.) The price of conversion is that income taxes must be paid as though the converted amount were distributed. You pay income taxes now instead of later, and future income and gains avoid all income taxes.

It can make a lot of sense to pay the taxes now when there will be 10 years or so of compounding to make up for the taxes. A converted Roth IRA also avoids required minimum distributions during the owner's lifetime.

Owners of large IRAs should look for opportunities to convert. When your income ordinarily exceeds the $100,000 level, there still might be years when a conversion is possible. If large deductible business losses are incurred one year, that year can be an ideal time to convert. The losses might bring adjusted gross income below the $100,000 limit. Losses also can be used to offset the conversion amount that must be included in income, reducing the cost of the conversion. Another good time to convert is when the owner is pushed into a lower tax bracket by losses or an income reduction.

The cost of the conversion can be reduced or made more affordable. For example, an IRA can be converted to a Roth over several years instead of in one year. That spreads out the tax bill and might reduce the total tax cost. Or you can wait for 2010 and the tax breaks available then. See my June 6, 2008 post.

Empty it early. You have been educated over the years to let tax deferral work for as long as possible. That is not always the best strategy.

The owner of a regular IRA must take required minimum distributions after age 70½. As the owner ages, the distributions increase. When the IRA is large, especially if the owner has significant other assets or income, the distributions will far exceed the owner's spending needs. The owner will be paying larger and larger income tax bills on income he doesn't need. The IRA in this case is intended as an emergency account and something to pass on to heirs, but after taxes the heirs will get a disappointing percentage of the IRA.

It is better in this situation to take money out of the IRA before it is needed, pay the taxes, and invest the after-tax amount. Then, there are several options that would reduce lifetime taxes below what they would be if the money were kept in the IRA.

The after-tax amount can be invested in taxable accounts for long-term capital gains. Taxes would be due only after assets were sold at a gain, or mutual funds made distributions. At current rates, long-term gains would be taxed at a maximum 15% instead of ordinary rates.

Another option is to give the distributions to relatives to use or invest. Instead of holding the IRA until heirs inherit it, give the money now. Heirs in lower tax brackets might be able to invest it at a lower tax rate than yours. Or they can spend it on things they need now.

Many IRA owners view their IRAs as emergency accounts or inheritances for their heirs. They have sufficient income from other sources that they do not plan to tap the IRAs during their lifetimes. People in this situation should consider emptying their IRAs early. The earlier the IRA is emptied, the better. You want as much future income out of the IRA and its high taxes as possible.

Annuitize. An IRA can be used to purchase an immediate annuity. The annuity makes fixed payments each year that are distributed to the owner. An annuitized IRA avoids minimum distribution rules, because it already is being distributed over the owner’s lifetime. The distributions will be fully taxable.

Annuitizing the IRA gives you the certainty of income for life and avoids higher taxes and distributions as you age. The downside is that there is nothing for your heirs under most annuity options.

Create multiple IRAs. Many people would benefit from more than one of these strategies. Others could benefit from using a strategy with part of their IRAs, but need the rest of the IRA for living expenses.

In these cases, it makes sense to divide an IRA into several IRAs. That makes it easy to keep track of your goals. Instead of tracking different amounts within one IRA, track different IRAs.

For example, you might plan to leave $50,000 to charity through your estate and are convinced an IRA is the best way to give. But you will need the rest of the IRA for living expenses and to leave to heirs. Rollover $50,000 of your current IRA into a new one (you might need a new custodian; some will not open more than one IRA for the same owner), and name the charity as beneficiary. You always can tap that IRA during your lifetime if the income is needed. Maintain the rest of your IRA money in the current IRA, and name loved ones as beneficiaries of that IRA.

Planning for New IRA Benefits in 2010

Bob Carlson — Fri, 06 Jun 2008 19:02:00 GMT

Retirement account owners, especially upper income owners, will receive significant new tax benefits in 2010. These benefits can be maximized if a plan of action is established now and implemented over the next few years.

Two tax benefits begin in 2010, if Congress does not change the law.

The first benefit is the repeal of the income limit on those who want to convert traditional IRAs into Roth IRAs. Currently, a traditional IRA can be converted into a Roth IRA only if the owner has adjusted gross income of no more than $100,000 in the year of the conversion (excluding income recognized by the conversion). If a married couple files jointly, the same $100,000 limit applies to their joint income. Beginning in 2010, taxpayers of any income level will be able to convert their IRAs into Roth IRAs.

The second benefit is that there will be a brief window when the tax from the conversion can be deferred, then paid over two years.

Normally, when a traditional IRA is converted into a Roth IRA, the converted amount is included in gross income in the year of the conversion. The IRA owner pays tax as though the converted amount were distributed. For conversions in 2010, however, the IRA owner has an option. The owner can choose to pay no taxes on the conversion in 2010 and to pay the taxes in equal shares in 2011 and 2012. In effect, the government is making interest-free loans to encourage people convert IRAs in 2010.

Why is the government doing this? Because of the strange accounting the government uses. A couple of years ago Congress needed a way to pay for some spending and tax cuts. A lot of IRA conversions will accelerate taxes that would have been paid over decades as the IRAs were gradually drawn down. The tax break that encourages people to convert their IRAs has the same budget effect as a tax increase.

There are several benefits to a Roth IRA, but they are back-loaded. There is no deduction for contributing money to a Roth. All income and gains earned by the Roth compound free of taxes. Distributions are tax free if they are made after the later of when the taxpayer first made a contribution to any Roth IRA and one of the following: the owner attained age 59½, is deceased, became totally disabled, or the distribution is of up to $10,000 and is used for the qualified purchase of a first home. Required minimum distributions are not imposed on the original owner; a beneficiary who inherits a Roth IRA takes RMDs over his or her life expectancy.

When distributions are not qualified, money still can be withdrawn tax free. That is because distributions from a Roth IRA are considered to first come from contributions, and the return of the contributions is free of taxes and penalties. Nonqualified distributions are taxable only after all contributions are withdrawn and income and gains are being withdrawn.

There are several cases when it makes sense to convert a traditional IRA to a Roth IRA despite the high initial tax cost.

Suppose an IRA owner has significant non-IRA income and assets and does not plan to draw down the IRA during his or her lifetime. The IRA is viewed as an emergency savings fund and something to be left to heirs when not needed. That is an expensive use of a traditional IRA. The owner must begin required minimum distributions after age 70½, and these will be taxed as ordinary income. That gives the owner taxable income he or she does not need. In addition, the IRA will be included in the estate and potentially subject to estate taxes. Unlike other assets, heirs do not increase the tax basis of the inherited IRA. Heirs must begin taking annual distributions from the IRA and include the distributions in ordinary income the same way the original owner would.

In the past I have recommended that people in this situation empty their IRAs early, pay the taxes, and invest the after-tax amount in taxable accounts. Future long-term capital gains and dividends would be taxed at their lower rates instead of at the ordinary income rate they would face when distributed from an IRA. In addition, heirs would get to increase the basis of the accounts when inherited. If done early enough, empty the IRA reduces lifetime taxes and increases a family’s after-tax wealth. Details of this strategy are in my book, The New Rules of Retirement.

In 2010 and later years, individuals in this situation are able to convert the traditional IRA into a Roth IRA instead of simply emptying the traditional IRA. The benefits of the Roth IRA increase the benefits of the strategy. The deferred payment of taxes that is possible by converting the IRA in 2010 also increases the benefits.

IRA owners who do not consider the traditional IRA a surplus asset still can benefit from a conversion. When does it make sense to convert a traditional IRA to a Roth IRA? There are several factors to consider.

How will taxes on the conversion be paid? The conversion is more valuable if the taxes are paid from non-IRA accounts so that the entire IRA is converted and begins compounding. If part of the IRA must be distributed and used to pay taxes, it takes longer for the conversion to pay off. In that case, if the IRA earns 8% annually it should be left to compound for at least 10 years before distributions begin.

Because of this it might make sense to convert an IRA over a period of years. Determine how much cash is available outside the IRA to pay income taxes, and convert the appropriate amount of the IRA for that level of taxes. More of the IRA can be converted in later years as cash is available to pay the taxes.
How long will the Roth IRA be left to compound before distributions begin? The converted amount must be allowed to compound its income and gains to make up for the taxes that were paid. If conversion taxes are paid from a taxable account and the IRA earns at least 8% annually, it takes at least seven years of compounding to reach the break even point. A longer compounding period generates more after-tax wealth for the owner than keeping the traditional IRA would have. A lower rate of return means a longer compounding period is needed to break even.
Will the tax rate be different when distributions begin? If the tax rate will be lower than it is today, it might not make sense to pay taxes at today's rate unless there is a substantial compounding period.
Will future Social Security benefits be taxable? If the taxpayer estimates having a high enough retirement income for benefits to be taxed, a conversion could reduce those future taxes. The Roth distributions are not included in gross income under current law while traditional IRA distributions are. If IRA distributions will be a big part of retirement income, shifting them to a Roth could save the Social Security benefits from taxes.
What will state income taxes be? Not all states exempt Roth IRA distributions from income taxes. This should be checked before a conversion is undertaken.

Many mutual funds and other financial services firms have calculators on their web sites to help determine if converting to a Roth IRA will increase after-tax wealth. A good calculator also can be found at www.rothira.com. A few of other calculators with no ties to financial products or services are at www.datachimp.com, www.volition.com, www.dinkytown.com, and www.customcalculators.com. Financial planners of course can make calculations.

IRA owners can enhance the conversion opportunity by getting ready for 2010 with the following steps.

Maximize IRA contributions. The more money you put into traditional IRAs now, the more you can convert in 2010. It even is sensible to make nondeductible contributions to IRAs with the intention of converting in 2010, because the money and its future income will be in a Roth IRA at some point. The taxes on the conversion will be very low because converting the nondeductible contributions won’t be taxable.

Maximize employer plan contributions. After leaving an employer, an employer can convert a retirement plan account, such as a 401(k), directly to a Roth IRA under recent rules changes. Or the owner can roll over the 401(k) balance to a traditional IRA and convert all or part of that to a Roth IRA in the future.

Generally, 401(k) amounts can be rolled over to an IRA only if the employee leaves the employer due to retirement, a new job, or disability. Some 401(k)s allow distributions or rollovers by any employee over age 59½. Check your plan's rules and the tax law before deciding to ramp up contributions with an eye toward a conversion to a Roth IRA.

Consider estate planning. Many people want children and grandchildren to benefit from their IRAs, but do not want to simply name them as beneficiaries. They prefer to leave the money through a trust. But naming a trust as a traditional IRA beneficiary is fraught with complications and must be done properly to avoid losing the tax deferral benefits of the IRA.

A Roth IRA, however, does not have those complications. A trust can be named the Roth IRA beneficiary without the worry of triggering premature taxes if the wording is not correct. A conversion to a Roth IRA in 2010 might enhance your estate plan.

Shape up IRA accounts. Many people established IRAs when the contribution limit was lower and the contributions were deductible at any income level. They have not paid much attention to the IRAs since they lost the ability to deduct contributions. Now is the time to identify all those IRAs. Begin to consolidate them at the broker or mutual fund company at which you eventually want to have your Roth IRA.

Plan for the future. Maybe your IRAs are small. You think they aren't worth the work of doing a conversion in 2010. But remember that the income limit for converting to a Roth IRA is repealed for all years beginning with 2010. That allows you effectively to make Roth IRA contributions every year beginning in 2010.

The strategy works like this. Establish a Roth IRA in 2010 with a conversion. Each year make contributions to a nondeductible IRA. Convert that IRA into a Roth by rolling the balance over to your existing Roth. Execute this plan each year or every few years if you want to limit paperwork. The result is that for a little extra paperwork you have avoided the contribution limit on Roth IRAs and established a tax free stream of retirement income.

Conversions of traditional IRAs to Roth IRAs can increase after-tax wealth for both the IRA owner and beneficiaries. Rules changes in 2010 enhance the benefits of a conversion. IRA owners can plan now to increase the benefits of the 2010 changes.