Partial Roth Conversion Strategy
October 13, 2009 by Jean Keener, CFP, CRPC, CFDS · Leave a Comment
When people find out how much tax they would have to pay to convert their IRA from traditional to Roth, it’s often times a conversion show stopper. Even if all the analysis shows that conversion would be clearly beneficial to their after-tax retirement income levels or provide estate planning benefits, there’s a gigantic psychological hurdle with writing a check to the IRS sooner rather than later. However, the conversion decision can become more attractive when you realize it’s not an all or nothing decision. You can choose to convert just part of your traditional IRA balance.
How do you decide how much to convert?
One reasonable way of determining how much to convert is doing enough to take you to the top of your current tax bracket without going into the next one. You might also determine how much of a tax bill you would be willing to pay, and then calculate the conversion amount based on that. For most, one of these two options will create the most appealing results.
There is a third option in the “fancy financial footwork” category.
This third option will result in far too much paperwork for many individuals to want to deal with it, especially for a smaller traditional IRA balance. But if you have a larger IRA – say $50,000 or more – the extra work might be worth the tax savings. Conversion is not an irrevocable decision until you get to the tax filing deadline of the next year (October 15 for most people). This 21-month window from January 2010 until the deadline to “recharacterize” the conversion creates a Roth Segregation Opportunity, pioneered by David Marotta of Marotta Wealth Management in Virginia and written up in a recent Financial Planning Magazine article.
Using the Roth Segregation Strategy, you convert your entire traditional IRA balance in January 2010. Let’s say the balance is $100,000 for easy math. Instead of putting the entire conversion in one account, you put $20,000 in each of 5 accounts. Each of these 5 accounts is invested in a different equity asset class – you might do 20% large cap growth, 20% large cap value, 20% small cap, 20% developed international, and 20% emerging markets. Then, around the beginning of October 2011, you assess which of these asset classes has performed the best. You keep the converted IRA with the best performance and recharacterize each of the other 4 back to traditional IRAs. This limits your tax liability (payable on 2011 and 2012 tax returns) to just the taxes on the $20,000. Of course, if multiple asset classes performed extremely well, you might choose to keep more of the conversions. Or if they all declined in value, you would likely recharacterize them all.
This strategy is not a simple one. It requires a lot of analysis and rigorous tracking of the paperwork to ensure that everything is completed properly. You would also want to ensure that going with such an aggressive equity allocation in your IRA over the 21-month period made sense within the larger context of your portfolio, time horizon, and risk tolerance. And for those that plan to do a full conversion vs. a partial, there’s no benefit to setting up all the different accounts.
But for those of you who relish a little financial creativity and don’t mind complexity, this can be a pretty cool opportunity to analyze and implement – and unique to the 2010 opportunity to spread taxes over 2011 and 2012.
Who should consider Roth conversion
September 18, 2009 by Jean Keener, CFP, CRPC, CFDS · 2 Comments
Given the historic opportunity of 2010 to spread the tax payment over 2 years in 2011 and 2012, everyone with a traditional IRA should take at least one look at Roth IRA conversion for next year.
It is most beneficial to you when all of these apply:
- You’ll pay the resulting “conversion” tax with non-IRA funds
- You have 10 years or more before you will be taking distributions from the Roth IRA
- You will be in the same or a higher tax bracket when you start taking those distributions.
But even if only some or none of these apply, it doesn’t mean you should rule conversion out.
There are still many times where it can make sense, and some that don’t. It’s easiest to discuss these by looking at few examples.
I did an analysis for a 64-year-old who didn’t have the money to pay the tax with non-IRA funds, so the taxes were going to come out of his IRA. He also only had 6 years until he planned to start taking distributions. He was going to be in the same tax bracket in 2011-2012 and in retirement. In his situation, he still came out ahead with conversion – having over $1,000 more in after-tax retirement income by converting. He won’t be subject to the 10% penalty on the amount withdrawn to pay the tax because he is over 59 ½. His situation was also helped by not planning to take social security until age 70. If he was already receiving social security benefits, we would have needed to consider any additional income tax implications on his social security benefits for the years he claimed the conversion income.
Another analysis was for a 32-year-old woman. She has a pre-tax employer
401k and was also trying to decide if conversion made sense. She also does not have the funds to pay the taxes with non-401k money, and she would be subject to the 10% penalty by withdrawing funds from the 401k before age 59 ½ to pay the taxes. We estimated her tax bracket in 2011-2012 and in retirement as the same. In her case, conversion did not make sense. But it was quite close. If she believed that her tax rates were going to be higher by the time she retired by even 1%, the conversion would have significantly increased her after-tax income.
One last example – 44 year old. He had a traditional IRA and had money to pay the taxes from a non-IRA account. However, we estimated that his tax bracket in retirement would likely be lower than it is now, by about 3%. In his case, conversion was still a great deal even with the projected lower retirement tax rate. Having all those years of after-tax growth more than off-set the potential for a slightly lower rate in retirement.
If you have a traditional IRA, an analysis is in order.
The above examples illustrate that even when your situation doesn’t meet the “ideal conversion” criteria, it still may make a significant difference in your after-tax retirement income. If you’d like to see the specific calculations on any of the examples listed above, please feel free to contact me and I’d be happy to send them to you.
A few other considerations to keep in mind
If your estate is potentially subject to the estate tax, a Roth conversion can be a powerful planning tool.
The market’s relative “high” or “low” value when you convert is also a factor in how good a deal conversion is – low values mean you pay tax on a lower amount.
There are also opportunities to convert in early 2010 and undo the conversion later based on circumstances or market performance. We’ll discuss this in future posts.
Roth IRA Conversion Overview
September 14, 2009 by Jean Keener, CFP, CRPC, CFDS · 2 Comments
Through 2009, converting an IRA from a traditional IRA to Roth is only available for those with household incomes under $100,000. Beginning next year, that changes. However, a lot of people aren’t aware of the upcoming changes — according to Financial Planning magazine, only 42% of advisor clients were aware of the new Roth IRA conversion opportunity. I will be doing a series of blog posts over the next couple of weeks giving you the details on this opportunity and some examples of who should consider this strategy. Of course, everyone’s situation is unique and these posts are for informational purposes only, so you should only make the decision after consulting with your own financial advisor.
First, why would you want to convert?
Funds withdrawn from a traditional IRA are subject to regular income tax. Funds withdrawn from a Roth IRA (both contributions and earnings) after age 59 1/2 and after you’ve owned the IRA for 5 years are federal income tax-free. By converting from a traditional to Roth IRA, you are paying taxes sooner rather than later on your IRA balance. This strategy allows your post-conversion earnings to avoid taxation altogether and to have potential tax savings on the contributions if your tax rate goes is higher in the future. It also gives you greater flexibility on when you use the funds because Roth IRAs do not have required minimum distributions. For some people, using this strategy can create a larger pool of after-tax retirement income and help with estate planning.
If you’d rather watch a video than read about the Roth IRA changes, this video comes from a service I subscribe to and provides a good overview of the conversion opportunity. Let me know what you think!
Roth IRA Conversion VideoEarly Retirees & Health Insurance
July 17, 2009 by Jean Keener, CFP, CRPC, CFDS · Leave a Comment
Thinking about retiring early? As part of the decision, you’ve got to calculate whether you’ll have enough retirement income to meet your needs. While adding up the costs of customary living expenses, utilities, and an occasional vacation, don’t forget to include another important retirement expense: health insurance.
We’re living longer and health-care costs are surging. Unless you qualify for Medicare (you must be at least 65 for coverage) or you’re very wealthy, you probably can’t afford to go without health insurance. And, unless you’re lucky, you probably can’t rely on your former employer for coverage, since few companies offer retiree health-care benefits. Underestimating the impact of medical costs could significantly hamper your plans for a comfortable retirement.
Check out your working spouse’s insurance to see if you can be added to his or her policy. But adding you as an insured likely will increase the premium cost to your spouse.
Ask your employer if it’s possible to remain covered under its group plan. Usually, plans don’t extend coverage beyond active employees and their dependents. But, it’s sometimes possible to remain covered, though you’ll probably have to reimburse your employer for the cost to keep you on the plan.
COBRA may be another option allowing you to remain covered under your employer’s group health plan. If your retirement causes you to lose your health insurance, you can remain on your employer’s plan for a maximum of 18 months (with some exceptions). You’ll have to pay the entire premium amount, plus a possible 2% administrative fee. And keep in mind that employers with fewer than 20 employees don’t have to offer COBRA, so it might not be available.
Shop for individual coverage
If you’re going to buy an individual health insurance policy, you may find the premium cost to be quite steep, especially if you’re also insuring your spouse and dependents. And there’s no guarantee you’ll even receive coverage. In most states, insurance companies can examine your health history and medical records (called underwriting) in order to determine whether you qualify for insurance and at what cost.
Saving a few premium pennies
Here are a few suggestions that might help you lower the cost of individual health insurance. Group rates are usually less expensive, so look for health insurance plans offered by trade associations or churches. Be aware that while coverage might cost less, you may have to pay a membership or association fee to the group offering the coverage. Also, the plan may have high deductibles and co-payments, and the benefits and options, including your choice of physicians and medical facilities, may be limited.
Also, in states that allow underwriting (Texas is one of them), the cost of an individual policy of health insurance is based, in part, on your age and health. A preexisting medical condition could affect your premium or even cause you to be denied coverage. So before applying for new health insurance, consider getting in better shape, especially if you think you’re a little overweight. Smoking is also a ticket to a higher premium, so quit if you can. Since the insurance company will examine your medical records, review them first with your doctor to remove any inaccuracies, and to clarify the reasons for examinations or treatments.
Finally, if you’re denied coverage because of poor health, don’t despair; you may still be able to get insurance if your state sponsors a high risk pool (Texas does). However, this is truly the option of last resort because of the high costs. As an example, pricing for a 60-year-old non-smoking male in some of the NE Tarrant County zip codes is $894 per month as August 1 for a $2,500 deductible plan. To see all the Texas high risk pool premiums, go to the Texas Department of Insurance website.
Roth 401(k) and 403(b)
June 24, 2009 by Jean Keener, CFP, CRPC, CFDS · Leave a Comment
One of my fellow Garrett Planning Network members, Jim Blankenship in New Berlin, Illinois, did a great summary article on Roth 401(k)s and 403(b)s yesterday.
More and more companies are making the Roth 401(k) or 403(b) an option. Legislation was also recently signed allowing the Roth option to be made available for government employees in the TSP.
The Roth is not right for everyone, but it’s a truly fabulous option for many of us. You don’t get tax savings now, but your money is able to grow and be withdrawn tax-free in retirement (once you meet certain conditions). If it’s available now through your employer, I would definitely suggest taking a few moments to read Jim’s article and consider whether it makes sense for you. Let me know of any questions!
February 2009 Newsletter
February 5, 2009 by Jean Keener, CFP, CRPC, CFDS · Leave a Comment
The February 2009 KFP newsletter is now available. The topics for this month are: What to do when your employer stops matching your 401(k), working during retirement, college costs update, and your credit score. There’s also some information on the Your Money Bus tour stop in D-FW. Enjoy!
Click here to view the February 2009 newsletter.
January 2009 Newsletter
January 9, 2009 by Jean Keener, CFP, CRPC, CFDS · Leave a Comment
The January 2009 newsletter is now available. It contains information on investing, saving for retirement, FDIC insurance, social security, financial preparedness for natural disasters, and information on upcoming events.