HOW A ROTH IRA CAN BE USED TO BE A POWERFUL INCOME AND ESTATE TAX PLANNING TOOL

We’ve all heard about Roth IRA’s by now, and how they help people save for retirement and deliver tax free distributions when that time comes. But many taxpayers overlook other strategies that utilize a Roth IRA which can have dramatic effects on your income taxes and your estate’s taxes. Let’s take a look at some aspects of a Roth IRA that you may want to consider.

Starting in 2008, qualified pensions, stock bonus plans, 401(k) plans, tax sheltered annuities, 403(b) and 457 plans can all roll over into a Roth account. Previously this treatment was only available to Traditional IRA accounts. These rollovers, called conversions, take money previously invested in plans that would result in taxable distributions and place those funds in a Roth, rendering them nontaxable when the funds ultimately are distributed to the owner. At the time of the conversion the owner (you) would include the amount converted into income and pay tax on the amount converted. This option is available for taxpayers whose modified adjusted gross income is less than $100,000 in the year of conversion (without taking into account the conversion amount).

Why would you want to do this? If you have large amounts of deductions that are either not being utilized on your tax return or are being wasted due to lack of income to offset them, or if your income level is unusually low in a particular year, you may want to take advantage of the situation and convert your deferred compensation into a Roth at little or no tax cost. Further, if your investment portfolio within your deferred comp plan(s) has declined in value, you may have a “perfect storm” of events coming together that would combine low conversion amounts with a low income tax level. Once the conversion is completed, any future appreciation on the investments in your Roth account would escape income taxation completely.

Another aspect of this strategy is estate planning. Income taxes avoided by converting assets into a Roth ultimately reduce your estate’s income tax burden by allowing any future appreciation to build inside the Roth account instead of inside a taxable account which could ultimately be taxed to your estate or heirs. Further, if you incur a tax on the conversion, you reduce your taxable estate by that amount as well.

So what’s the catch?

Not everyone qualifies to convert a Roth. If your Adjusted Gross Income is over $100,000 you will have to wait until 2010 to convert. The income limitation is scheduled to end after 2009. Further, careful analysis should be done prior to converting in order to weigh any taxes paid up front against the potential future benefits. Conversions can be unwound, (called “re-characterization”), but you will have to monitor the assets for drops in value after your conversion to see if re-characterization is beneficial.

Paul Scholz, CPA