How the IRS plans to get at more of your money (nerd's eye view at kitces.com)

President’s Budget Proposes Elimination Of Backdoor Roth, Stretch IRA, and Step-Up In Basis At Death!

FEBRUARY 10, 2016 12:45 PM 

Every February, the President formulates a budget request for the Federal government, which Congress then considers in coming up with its own budget resolution. And while many provisions of the President’s budget pertain to actual recommendations on appropriations for various government agencies, the proposals often include a wide range of potential tax law changes, recorded in the Treasury Greenbook.

Given that this is an election year and already within less than 12 months of the end of President Obama’s term, there is little likelihood that any of the President’s substantive tax changes will actually come to pass, from a version of the so-called “Buffet Rule” (a “Fair Share Tax” for a minimum 30% tax on ultra-high income individuals), an increase in the maximum capital gains rate to 24.2% (which would total 28% including the 3.8% Medicare surtax on net investment income), or a rewind of the estate tax exemption back to the $3.5M threshold from 2009.

However, the President’s budget proposals do provide an indication of what’s “on the radar screen” inside Washington, including a wide range of potential “crackdowns” and “loophole closers” that could appear in legislation (as was the case with the crackdown on Social Security file-and-suspend and restricted-application claiming strategies last year).

And in this context, it’s notable that the President’s budget proposal does include a wide range of potential crackdowns on individuals, from a new cap on the maximum gain to be deferred in a 1031 like-kind exchange of real estate, to the addition of lifetime Required Minimum Distributions for Roth IRAs after age 70 ½, the elimination of stretch IRAs and step-up in basis at death, shutting down the “backdoor Roth contribution” strategy, and more!

“Loophole Closers” And Other Retirement Planning Crackdowns In The Treasury Greenbook

When it comes to cracking down on retirement accounts, the President’s budget re-proposes a series of new restrictions and limitations, from killing the so-called “backdoor Roth IRA” to the stretch IRA.

Fortunately, the reality is that all of these crackdowns have appeared in prior proposals, and none have been enacted – which means it’s not necessarily certain that any of them will be implemented this year either, especially given that it is both an election year (which tends to slow the pace of tax legislation), and that there won’t even be any Tax Extenders legislation this December after last year’s permanent fix.

Nonetheless, the proposals provide some indication of what could be on the chopping block, should any legislation happen to be going through Congress that needs a “revenue offset” to cover its cost.

Key provisions that could be changed in the future include:

ELIMINATION OF BACK DOOR ROTH IRA CONTRIBUTIONS

The back door Roth IRA contribution strategy first became feasible in 2010, when the income limits on Roth conversions were first removed. Previously, those with high income could not make a Roth IRA contribution, nor convert a traditional IRA into a Roth. With the new rules, though, it became possible for high-income individuals ineligible to contribute to a Roth IRA to instead contribution to a non-deductible traditional IRA and complete a Roth conversion of those dollars – effectively achieving the goal of a Roth IRA contribution through the “back door”.

Arguably, completing a backdoor Roth IRA contribution was already at risk of IRS challenge if the contribution and subsequent conversion are done in quick succession, but the proposal in the Treasury Greenbook would crack down further by outright limiting a Roth conversion to only the pre-tax portion of an IRA. Thus, a non-deductible (after-tax) contribution to a traditional IRA would no longer be eligible for a Roth conversion at all (nor any existing after-tax dollars in the account).

Notably, a matching provision would apply to limit conversions of after-tax dollars in a 401(k) or other employer retirement plan as well, limiting the “super backdoor Roth” contribution strategy that was made possible by IRS Notice 2014-54.

If enacted, the new rule would simply prevent any new Roth conversions of after-tax dollars after the effective date of the new legislation.

INTRODUCE REQUIRED MINIMUM DISTRIBUTION (RMD) OBLIGATIONS FOR ROTH IRAS

Under the auspices of “simplifying” the required minimum distribution (RMD) rules for retirement accounts, the President’s budget proposal would “harmonize” the RMD rules between Roth and traditional retirement accounts.

This change would both introduce the onset of RMDs for those with Roth IRAs and Roth employer retirement plans upon reaching age 70 ½ (ostensibly the still-employed exception for less-than-5% owners would still apply to employer retirement plans).

Notably, this “harmonization” rule would also prevent any additional contributions to Roth retirement accounts after reaching age 70 ½ (as is the case for traditional IRAs).

ELIMINATION OF STRETCH IRA RULES FOR NON-SPOUSE BENEFICIARIES

First proposed nearly 4 years ago as a revenue offset for highway legislation, and repeated in several Presidential budget proposals since then, the current Treasury Greenbook once again reintroduces the potential for eliminating the stretch IRA.

Technically, the new rule would require that the 5-year rule (where the retirement account must be liquidated by December 31st of the 5th year after death) would become the standard rule for all inherited retirement (including traditional and Roth) accounts. In the case of a retirement account bequeathed to a minor child, the five year rule would not apply until after the child reached the age of majority.

In the case of beneficiaries who are not more than 10 years younger than the original IRA owner, the beneficiary will still be allowed to stretch out required minimum distributions based on the life expectancy of the beneficiary (since the stretch period would not be materially different than the life expectancy of the original IRA owner). A special exception would also allow a life expectancy stretch (regardless of age differences) for a beneficiary who is disabled or chronically ill.

LIMIT NEW IRA CONTRIBUTIONS FOR LARGE RETIREMENT ACCOUNTS (OVER $3.4M)

First introduced in the President’s FY2014 budget, this year’s Treasury Greenbook also re-proposes a rule that would limit any new contributions to retirement accounts once the total account balance across all retirement accounts reaches $3.4M. As long as the end-of-year account balance is above the threshold, no new contributions would be permitted in the subsequent year (though if the account balance dipped below the threshold, contributions would once again become possible, if otherwise permitted in the first place). All account balances across all types of retirement plans (not just IRAs) would be aggregated to determine if the threshold has been reached each year.

The dollar amount threshold is based on the cost to purchase a lifetime joint-and-survivor immediate annuity at age 62 for the maximum defined benefit pension amount of $210,000(which means the dollar amount could change due to both inflation-indexing of this threshold, and also any shifts in annuity costs as interest rates and mortality tables change over time).

Notably, the proposed rule would not force existing dollars out of a retirement account once the threshold has been reached. There are no requirements for distribution to get under the threshold, and the rule explicitly acknowledges continued investment gains could propel the account balance further beyond the $3.4M level. The only limitation is that no newcontributions would be permitted.

REPEAL OF NET UNREALIZED APPRECIATION RULES FOR EMPLOYER STOCK IN AN EMPLOYER RETIREMENT PLAN

In the section of “loophole” closers, the President’s budget proposes (for the second year in a row) to eliminate the so-called “Net Unrealized Appreciation” rules, which allow for employer stock in an employer retirement plan to be distributed in-kind to a taxable account so any of the gains in the stock (the unrealized appreciation) can be sold at capital gains rates.

Characterizing these NUA rules as a “loophole” is ironic, given that the strategy is explicitly permitted under IRC Section 402(e)(4), and has been in existence as an option for employees with holdings in employer stock since the Internal Revenue Code of 1954!

Of course, employee savings habits have changed significantly since the 1950s, as has our understanding of investing and portfolio diversification. The proposed justification for the elimination of NUA is that employer retirement plans now have many other tax preferences, and that at this point the NUA could be an inappropriate incentive for employees to concentrate their investment risks in their employer stock (which further concentrates their risk given that their job is also reliant on the same employer!). The proposal also specifically cites a concern that the NUA benefit may be ‘too’ generous when used with employer stock in an ESOP, which already enjoys other tax preferences.

To ease the transition for those who have already been accumulating employer stock in their retirement plan for many years, the proposal would only apply for those who are younger than age 50 this year (in 2016). Anyone who is already 50-or-older in 2016 would be grandfathered under the existing rules, and retain the right to do an NUA distribution in the future.

Ending GRATs and IDGTs, And Other Estate Planning Crackdowns In The President’s FY2017 Budget Proposal

The President’s budget proposal also includes a number of estate-planning-related crackdowns and loophole closers. As with most of the proposals for changes to retirement accounts, these potential “loophole closers” are not new, but do represent the broadest list yet of areas that the IRS and Treasury wish to target.

ELIMINATION OF THE GRANTOR RETAINED ANNUITY TRUST (GRAT) STRATEGY

The Grantor Retained Annuity Trust (GRAT) is an estate planning strategy where an individual contributes funds into a trust, in exchange for receiving fixed annuity payments back from the trust for a period of time. Any funds remaining in the trust at the end of the time period flow to the beneficiaries.

To minimize current gift tax consequences, the strategy is often done where the grantor agrees to receive a series of annuity payments that are almost equal to the value of the funds that went into the trust – for instance, contributing $1,000,000 and agreeing to receive in exchange payments of $500,000. To the extent any growth above those payments results in extra funds left over at the end, they pass to the beneficiaries without any further gift tax consequences.

In today’s low interest rate environment, this strategy has become extremely popular, because the methodology to determine the size of the gift is based on calculating the present value of the promised annuity payments. The lower the interest rate, the less the discounting, the more the assumed annuity will return to the original grantor, and the small the gift. In some cases, grantors will simply create a series of “rolling” GRATs that run for just 2 years and start over again, just trying over and over again to see if one of them happens to get good investment performance to transfer a significant amount to the next generation tax-free (as the remainder in the trust).

To crack down on the strategy, the President’s budget proposes that the minimum term on a GRAT would be 10 years (which largely eliminates the relevance of rolling GRATs and introduces far more risk to the equation for the grantor). In addition, the rules would require that any GRAT remainder (the amount to which a gift would apply) must be the greater of 25% of the contribution amount, or $500,000, which both increases the size of the GRAT that would be necessary to engage in the strategy and forces the grantor to use a material portion of his/her lifetime gift tax exemption to even try the strategy.

To further eliminate the value of the strategy, the proposal would also require that in any situation where a grantor does a sale or exchange transaction with a grantor trust, that the value of any property that was exchanged into the trust remains in the estate of the grantor – included in his/her estate at death, and subject to gift tax during his/her life when the trust is terminated and distributions are made to a third party. This would likely kill the appeal of the GRAT strategy altogether, as it would cause the remaining value of a GRAT distributed to beneficiaries at the end of its term to still be subject to gift taxes.

Notably, this crackdown on transfers via a sale to a grantor trust would indirectly also eliminate estate planning strategies that involve an installment sale to an intentionally defective grantor trust (IDGT), as the inclusion of the property exchanged into the trust would prevent the grantor from shifting the appreciation outside of his/her estate.

ELIMINATE DYNASTY TRUSTS WITH MAXIMUM 90-YEAR TERM

Historically, common law has prevented the existence of trusts that last “forever”, and most states have a “rule against perpetuities” that limits a trust from extending more than 21 years after the lifetime of the youngest beneficiary alive at the time the trust was created.

However, in recent years, some states have begun to repeal their rules against perpetuities – largely in an effort to attract trust business to their state – and creating the potential of “dynasty” trusts that exist indefinitely for a family, and allow the indefinite avoidance of estate (and generation-skipping) taxes for future generations of the family.

To prevent the further creation of new dynasty trusts, the President’s budget proposal would cause the Generation Skipping Tax exclusion to expire 90 years after the trust was created. As a result, the Generation Skipping Transfer Tax itself could then be applied to subsequent distributions or terminations of the trust, eliminating the ability for subsequent skipping of estate taxes for future generations.

Notably, the proposed rule would only apply to new trusts created after the rule is enacted, and not any existing trusts. However, new contributions to existing trusts would still be subject to the new rules as proposed.

LIMIT TOTAL OF PRESENT INTEREST GIFTS THROUGH CRUMMEY POWERS

IRC Section 2503(b) allows for an annual gift tax exclusion (currently $14,000 per donee in 2016) for gifts that are made every year. However, an important caveat to the rule under IRC Section 2503(b)(1) is that in order to qualify for the exclusion, the gift must be a “present interest” gift to which the beneficiary has an unrestricted right to immediate use.

The present interest gift requirement makes it difficult to use the annual gift tax exclusion for gifts to trusts, as contributing money into a trust that won’t make distributions until the (possibly distant) future means by definition the beneficiary doesn’t have current access to the funds. It’s not a “present interest” gift, and thus cannot enjoy the $14,000 gift tax exclusion.

The classic strategy to work around this rule has been to give the trust beneficiaries an immediate opportunity to withdraw funds as they are first contributed to the trust. The fact that the beneficiary has an immediate withdrawal power ensures that it is a “present interest” gift and eligible for the exclusion. However, the trust is commonly structured to have that beneficiary’s right-to-withdraw lapse after a relatively limited period of time, such that in the short run it’s a present interest gift but in the long run it still accomplishes the goals of the trust. This strategy has been permitted for nearly 50 years, since the famous Crummey Tax Court case first affirmed it was legitimate (such that these present-interest-lapsing powers are often called “Crummey powers”).

However, in recent years a concern has arisen from the IRS is that some trusts had a very large number of Crummey beneficiaries, all of whom would have Crummey powers, such that the donors could gift significant cumulative dollar amounts out of their estate by combining together all the beneficiaries. In some scenarios, there were even concerns that the Crummey beneficiaries had no long-term interest in the trust at all, and were just operating as ‘placeholders’ to leverage gift exclusions. Unfortunately, though, from the IRS’ perspective, the Service has been unable to successfully challenge these in court.

Accordingly, the new proposal would alter the tax code itself to impose limit the total amount of such gifts. The change would be accomplished by actually eliminating the present interest requirement for gifts to qualify for the annual gift tax exclusion, and instead simply allowing a new category of future-interest gifts, but only for a total of $50,000 per year for a donor (regardless of the number of beneficiaries). The new category of gifts would include transfers into trusts, as well as other transfers that have a prohibition on sale, and also transfers of interests in pass-through entities.

Notably, this rule wouldn’t replace the $14,000 annual gift tax exclusion. Instead, it would simply be an additional layer that effectively limits the cumulative number of up-to-$14,000 per-person gifts if they are in one of the new categories (e.g., transfers into trusts). For instance, if four $14,000 gifts were made to four beneficiaries of a trust, for a total of $56,000 of gifts, each $14,000 gift might have individually been permissible, but the last $6,000 would still be a taxable gift (or use a portion of the lifetime gift tax exemption amount) because it exceeds the $50,000 threshold.

It is also notable that since the new category includes “transfers of interests in pass-through entities”, the rule may be used to limit aggressive present-interest gifting of family limited partnership shares across a large number of family members!

Ending Step-Up In Basis And Other Income Tax And Capital Gains Proposed Crackdowns

In addition to the targeted retirement and estate planning crackdowns, it’s notable that the President’s budget proposal includes several additional rules that would impact general income tax strategies, particularly regarding planning for and around capital gains.

ELIMINATION OF STEP-UP IN BASIS, TO BE REPLACED BY A REQUIRED-SALE-AT-DEATH RULE

As a part of the Economic Growth and Tax Relief Reconciliation Act of 2001, Congress repealed the estate tax in 2010, and at the same time repealed the existing rules allowing for a step-up in basis, to be replaced with a rule for “carryover cost basis” from the decedent to the beneficiary.

The problem with carryover cost basis rules at death is that they are extremely problematic to administer. Beneficiaries (and/or the executor) don’t necessarily know what the cost basis was in the first place for many investments, or lose track of it, especially if the property isn’t sold until years later. In practice, step-up in basis at death functions as much as a form of administrative expediency for administering the tax code, as an intended “tax break” at death.

Accordingly, the President’s budget proposes a new way to handle the situation: simply tax all capital gains at death, as though the decedent had liquidated all holdings. The capital gains would be reported on the decedent’s final income tax year, and gains could be offset by any capital losses in that year, and/or any capital loss carryforwards. There would an exclusion for the first $100,000 of capital gains (eliminating any capital gains exposure for the mass of Americans with moderate net worth), in addition to a $250,000 exclusion for any residence. Any household furnishings and personal effects would also be excluded from consideration.

Assets bequeathed to a surviving spouse would still retain a carryover in basis, and any unused capital gains exclusion (the $100,000 amount for general property and the $250,000 for a residence) would be portable and carry over (thus making the exclusions $200,000 and $500,000, respectively, for a married couple, due at the second death of the couple). Any transfers to a charity at death would also not be subject to the capital gain trigger.

To avoid lifetime avoidance of the tax through gifting, the proposal would also eliminate carryover cost basis for gifts, and instead require the same capital-gains-upon-transfer rule for a lifetime gift (again with carryover cost basis applying only for gifts to a spouse or charity).

LIMIT 1031 LIKE-KIND EXCHANGES OF REAL ESTATE TO A $1,000,000 ANNUAL LIMIT

Under IRC Section 1031, investors are permitted to exchange a real estate investment for another “like-kind” piece of real estate, while deferring any capital gains on the transaction. For the purpose of these rules, “like kind” is broadly interpreted, even including the swap of unimproved real estate (i.e., raw land) for improved real estate (e.g., an apartment building) or vice versa.

Congress notes that historically, the rules for like-kind exchanges for real estate (and other illiquid property) were allowed primarily because such property could be difficult to value in the first place, such that it was easier to simply permit the exchange and tax the final transaction later, rather than try to set an appropriate value at the time of the transaction (if the investor wasn’t converting the property to cash anyway).

However, given that property is far more easily valued now than it was decades ago when the 1031 exchange rules were originated, the President’s budget proposes to limit the rule to only $1,000,000 of capital gains that can be deferred in a 1031 exchange in any particular year. Any excess gain above that amount in a particular year would be taxable as a capital gain, as though the property had been sold in a taxable event, with the proceeds separately reinvested.

The proposal would also eliminate the 1031 exchange rules for art and collectibles altogether.

ELIMINATION OF SPECIFIC LOT IDENTIFICATION FOR SECURITIES AND REQUIREMENT TO USE AVERAGE COST BASIS

Under the tax code, investors that hold multiple shares of property can choose which lots are sold. In the case of dissimilar property like multiple lots of real estate, this rule simply recognizes that only the actual lot being sold should be taxed. However, the case is less clear for portfolio investments, where market-traded securities are fungible and “economically indistinguishable” from each other.

Accordingly, the President’s budget proposes to eliminate the specific lot identification method for “portfolio stock” held by investors, along with any ability to choose a FIFO or LIFO default cost basis methodology,  and instead require investors to use average cost basis instead (in the same manner as is done for mutual funds. The rule would only apply to stocks that had been held for more than 12 months, such that they are eligible for long-term capital gains treatment, and would apply to all shares of an identical stock, even if held across multiple accounts or brokerage firms. However, it would only apply to “covered securities” that are subject to cost basis tracking in the first place (generally, any stocks purchased after January 1st of 2011).

Notably, this change was proposed previously in the President’s FY2014 budget as well. Its primary impact would be limiting the ability to “cherry pick” the most favorable share lots to engage in tax-loss harvesting (or 0% capital gains harvesting) from year to year.

APPLY THE 3.8% NET INVESTMENT INCOME MEDICARE SURTAX TO S CORPORATIONS

A long-standing concern of the IRS has been the fact that while pass-through partnerships require partners to report all pass-through income as self-employment income (subject to Social Security and Medicare self-employment taxes), the pass-through income from an S corporation is treated as a dividend not subject to employment taxes. Historically this has allowed high-income S corporation owners to split their income between self-employment-taxable “reasonable compensation” and the remaining income that is passed through as a dividend not subject to the 12.4% Social Security and 2.9% Medicare taxes. (Most commonly though, the strategy “just” avoids the 2.9% Medicare taxes, as reasonable compensation typically is high enough to reach the Social Security wage base anyway.)

Since the onset of the new 3.8% Medicare surtax on net investment income in 2013 (along with a new 0.9% Medicare surtax on upper levels of employment income), the stakes for this tax avoidance strategy have become even higher, as upper income individuals (above $200,000 for individuals or $250,000 for married couples) are now avoiding a 3.8% tax (either in the form of 2.9% Medicare taxes plus the 0.9% surtax on employment income, or the 3.8% tax on investment income).

To curtail the strategy, the President’s budget proposal would automatically subject any pass-through income from a trade or business to the 3.8% Medicare surtax, if it is not otherwise subject to employment taxes. This effectively ensures that the income is either reported as employment income (subject to 2.9% + 0.9% = 3.8% taxes), or is taxed at the 3.8% rate for net investment income instead.

In addition, in the case of professional service businesses (which is broadly defined to include businesses in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, as defined for qualified personal service corporations under the IRC Section 448(d)(2)(A), as well as athletes, investment advisors/managers, brokers, and lobbyists), the rules would also outright require that S corporation owners who materially participate in the business would be required to treat all pass-through income as self-employment income subject to self-employment taxes (including the 0.9% Medicare surtax as applicable).

NEW SCRUTINY OF LIFE SETTLEMENTS AND LIMITATIONS ON THE TRANSFER-FOR-VALUE RULES

The growth of life settlements transactions in recent years – where a life insurance policyowner sells the policy to a third party, who then keeps the policy ‘as an investment’ until the insured passes away – has brought a growing level of scrutiny to the area.

Under the standard rules for life insurance, IRC Section 101(a)(1) permits a life insurance death benefit to be paid out tax-free to the beneficiary. However, that tax preference is only intended for the original policyowner (who had an insurable interest in the insured), and not necessarily an investor. In fact, IRC Section 101(a)(2) explicitly requires that if a life insurance policy is “transferred for valuable consideration” (i.e., sold) that the death benefits become taxable. Exceptions apply for scenarios where the buyer is the insured (e.g., buying back his/her own policy from a business), or in certain scenarios where the policy is bought by a business or a partner of the business.

From the perspective of the IRS, the primary concern is that some life settlement investors may be evading these rules by forming “business” entities where they can be a partner of the insured (even if the insured just becomes a 0.1% owner), just to buy the policy in a tax-free context.

Accordingly, the President’s budget proposal would modify the transfer-for-value rules by requiring that the insured be (at least) a 20% owner of the business, in order to avoid having minimal partners added just to avoid the standard life settlements tax treatment.

In addition, the new rules would require that, for any insurance policy with a death benefit exceeding $500,000, that details of the life settlements purchase – including the buyer’s and seller’s tax identification numbers, the issuer and policy number, and the purchase price – be reported both to the insurance company that issued the policy, the seller, and the IRS so the Service can track life settlements policies. In addition, upon death of the insured, the insurance company would now be required to issue a reporting form for the buyer’s estimate cost basis and the death benefit payment, along with the buyer’s tax identification number, to the IRS so the Service can ensure (and potentially audit) that the gain was reported appropriately. (For those who actually do report life settlements gains properly, this part of the new rule would have no impact, beyond just confirming what was already reported.)

Silver Linings In The President’s FY2017 Budget Proposals

Notwithstanding all the looming “crackdowns”, it’s important to note that not everything in the Treasury Greenbook is “negative” when it comes to financial planning. There are some silver linings. Favorable provisions include:

– Elimination of Required Minimum Distribution obligations for those with less than $100,000 in retirement accounts upon reaching age 70 1/2

– Marriage penalty relief in the form of a new up-to-$500 two-earner tax credit

– Consolidation of the Lifetime Learning Credit and Student Loan Interest Deduction into a further expanded American Opportunity Tax Credit

– Expansion of the exceptions to the IRA early withdrawal penalty to include living expenses for the long-term unemployed

– Ability to complete an inherited IRA 60-day rollover

– Expansion of automatic enrollment of IRAs and multi-employer small business retirement plans

Of course, as with the proposed loophole closers, these silver lining proposals aren’t likely to see implementation in 2016 either. Nonetheless, they form the basis for potential points of change and compromise for tax reform in 2017… which means it’s not likely the last time you’ll be hearing about these potential changes either!

The Rules: Roth IRA Conversions (from Kiplinger.com)

The Back-door Roth IRA ( from Natalie Choate, ataxplan.com)

How to get around the Income Limit for Roth IRAs

Question: If a high-income taxpayer makes a nondeductible IRA contribution, is he free to convert it to a Roth IRA immediately? Or would this be deemed an excess Roth conversion if done in the same year?

Natalie: He is free to convert it immediately. It would not be deemed an excess Roth IRA contribution. There's no legally required waiting period; however, it would make sense to wait until you have received adequate documentation that the original contribution was made to a traditional IRA, just so the record is absolutely clear.

For some reason, Congress left income limits in place for making "regular" (annual-type) contributions to a Roth IRA, even though they removed the income limit for conversion contributions. So this sequence (contribute to a traditional IRA, then immediately convert the account to a Roth) will be very popular with everyone who (1) wants to make a regular contribution to a Roth IRA but is ineligible to do so and (2) is eligible to contribute to a traditional IRA. To be eligible to make a regular contribution to a traditional IRA you must have compensation income at least equal to the contributed amount and be younger than age 70½ as of the end of the contribution year.

As a reminder, the fact that the participant is converting a newly-created IRA (funded with a nondeductible contribution) does not mean that the conversion is automatically "tax-free." The conversion of a newly-created traditional IRA is taxed just like the conversion of any other traditional IRA; you do not look only at the pre- and after-tax money in the particular account he happens to be converting.

The nontaxable portion of any IRA conversion (whether of a brand new account or an IRA you've held for years) is determined the same way. You multiply the converted amount by a fraction. The numerator of the fraction is the total amount of after-tax money the participant has in all of his traditional IRAs. The denominator is the total combined value of all of the participant's IRAs. The amount that results from applying this fraction is the only amount that you can treat as the tax-free conversion of after-tax funds-regardless of which account the conversion actually came from.

Example: Fred and Ed each make nondeductible $5,000 contributions to their respective newly created traditional IRAs on Monday, March 1, 2010. A week later, each of them converts his newly created $5,000 traditional IRA to a Roth IRA. Even though they both followed exactly the same steps, they have very different tax results.

For Fred, the newly created $5,000 traditional IRA is the ONLY traditional IRA that he owns. Fred's conversion is "tax free" because he's converting 100 percent after-tax money.

Ed, on the other hand, in addition to his newly created $5,000 traditional IRA, also owns a $95,000 rollover traditional IRA. The rollover IRA is 100 percent pretax money. To determine how much of Ed's 2010 conversion is tax-free, we multiply the $5,000 conversion amount by the following fraction:

$5,000 (that's the total of Ed's after-tax money in both of his traditional IRAs)
$100,000 ($95,000 + $5,000; the total combined value of all Ed's traditional IRAs)

$5,000/$100,000 times $5,000 = 5%, meaning that only $250 of the $5,000 conversion is deemed to come from the after-tax money in Ed's IRAs. The other $4,750 of his conversion is included in his gross income.

I have simplified the fraction for purposes of illustration; it's actually based on year-end values.

So yes the strategy is legal and safe and it works--but don't fall into the trap of thinking the conversion is automatically tax-free just because you are converting a new account funded only with nondeducted contributions.
Resources: See Chapter 2 of the author's book Life and Death Planning for Retirement Benefits for how to compute the taxable and tax-free portion of any distribution; $89.95 plus shipping at www.ataxplan.com or 800-247-6553. For complete explanation of all aspects of Roth IRAs and other Roth retirement plans, get Natalie's 97-page Special Report Roth-Ready for 2010!, downloadable for $49.95 at www.ataxplan.com.

Quick Tax Info: Codes in the Box in 1099 R (retirement withdrawal)

On my 1099-R, what do the codes mean?

1—Early distribution, no known exception (in most cases, under age 59 1⁄2 ).

2—Early distribution, exception applies (under age 59 1⁄2 ).

3—Disability.

4—Death.

5—Prohibited transaction.

6—Section 1035 exchange (a tax-free exchange of life insurance, annuity, or endowment contracts).

7—Normal distribution. Over 59 1/2 years old.

8—Excess contributions plus earnings/excess deferrals (and/or earnings) taxable in 2009.

9—Cost of current life insurance protection (premiums paid by a trustee or custodian for current insurance protection, taxable to you currently).

A—May be eligible for 10-year tax option.

D—Excess contributions plus earnings/excess deferrals taxable in 2009.

E—Excess annual additions under section 415 and certain excess amounts under section 403(b) plans. Report on Form 1040/1040A on the line for taxable pension or annuity income. If the IRA/SEP/SIMPLE box is checked, you have received a traditional IRA, SEP, or SIMPLE distribution.

F—Charitable gift annuity.

G—Direct rollover to a qualified plan, a tax-sheltered annuity, a governmental 457(b) plan, or an IRA. May also include a transfer from a conduit IRA to a qualified plan.

J—Early distribution from a Roth IRA, no known exception (in most cases, under age 59 1⁄2 ). Report on Forms 1040 and 8606 and see Form 5329.

L—Loans treated as distributions.

N—Recharacterized - IRA contribution made for 2009 and recharacterized in 2009. Report on 2004 Form 1040/1040A and Form 8606, if applicable.

P—Excess contributions plus earnings/excess deferrals taxable in 2009.

Q—Qualified distribution from a Roth IRA. You are age 59 1⁄2 or over and meet the 5-year holding period for a Roth IRA.

R—Recharacterized IRA contribution made for 2009 and recharacterized in 2009.

S—Early distribution from a SIMPLE IRA in first 2 years, no known exception (under age 59 1⁄2 ). May be subject to an additional 25% tax.

T—Roth IRA distribution, exception applies. (You may not meet the 5-year holding period.) You are either age 59 1⁄2 or over or an exception (code 3 or 4) applies.

Convert To Roth IRA - Not So Fast

Advisors Caution Against Rush To Roth IRA

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Is Converting to a Roth IRA for You? (WSJ)

RETIREMENT PLANNING
DECEMBER 6, 2009
Get Ready for 2010—the Year of the Roth IRA

By ANNE TERGESEN
New tax rules are about to give more people access to a Roth individual retirement account, one of the most effective vehicles in which to accumulate money for retirement or heirs.

Roth IRAs are currently off-limits to a whole group of people. Individuals with modified adjusted gross income of $120,000 or more can't contribute to one of these accounts. For married couples, the threshold is $176,000. And individuals with modified adjusted gross income of more than $100,000 and married taxpayers who file separate returns are barred from moving assets held in traditional IRAs into Roth IRAs.



But starting Jan. 1, Uncle Sam will permanently eliminate both the income and filing-status restrictions on transferring money from a traditional IRA to a Roth -- a procedure known as converting. So, anyone willing to pay the income taxes due upon making such a move will be able to funnel retirement savings into a Roth, where it can grow tax-free.

Money When You Want It
Under the new rules, high-income taxpayers who wish to contribute to a Roth IRA are still out of luck: Income limitations on funding these accounts will remain in effect. However, Uncle Sam's decision to allow high earners to convert will give these individuals a back-door way to fund a Roth on a continual basis.
How so? Each year, these taxpayers can open a traditional IRA (which has no income limits) and contribute the maximum (currently, $6,000 for individuals age 50 and older) on a pretax or aftertax basis. Then, they can convert the assets to a Roth IRA.
Why bother with a conversion? Roths have several advantages over traditional IRAs.

Perhaps the biggest one concerns taxes -- or a lack thereof. For the most part, withdrawals from Roth IRAs are tax-free as long as an account holder meets the rules for minimum holding periods. If you convert assets to a Roth from other IRAs or retirement plans, you have to hold those assets in a Roth for five years, or until you turn age 59½, whichever comes first, to make penalty-free withdrawals on your converted amounts. Each conversion has its own five-year clock.

Another benefit: no required distributions. With a traditional IRA, individuals are required to begin tapping their accounts -- and to pay taxes on those withdrawals -- after reaching age 70½. Roth accounts aren't subject to mandatory distributions, so the money in a Roth can grow tax-free for a longer period of time.

If you are planning to leave your IRA to heirs, Roths have yet another advantage. Although people who inherit both traditional and Roth IRAs must make annual withdrawals from those accounts (based on their life expectancies), Roth beneficiaries owe no income tax on the money.

Tax Bill Upfront
Still, there is a cost to converting to a Roth -- namely, the income-tax bill. When you withdraw money from your traditional IRA, you will have to pay income tax on the withdrawal, or, more precisely, on the portion of it that represents pretax contributions and earnings.
In 2010, Uncle Sam is offering taxpayers who convert a special deal: They can choose to report the amount they convert on their 2010 tax returns, or they can spread it equally across their 2011 and 2012 returns. (If you are worried that Congress may raise tax rates, consider paying the tax bill in 2010.)

To determine whether it makes financial sense for you to convert, it's important to consider various factors. For example, converting may be the right move if you expect to pay higher future tax rates or if the value of your IRA account is temporarily depressed, says Ed Slott, an IRA consultant in Rockville Centre, N.Y. In either case, by converting to a Roth today you'll lock in a lower tax bill than you would otherwise pay.

To estimate your potential tax bill, first calculate your "basis." Expressed as a percentage, this is the ratio of two numbers: aftertax contributions you have made to your IRAs (if any), and the total balance in all your IRAs.

For example, if you contributed $40,000 aftertax to your IRAs and have a total of $250,000 in those accounts, your basis would be 16% (or $40,000 divided by $250,000). As a result, if you plan to convert $100,000 to a Roth, 16% of that $100,000 (or $16,000) could be transferred tax-free.

Another factor is how long you can afford to leave the money in a Roth. Because the Roth's major advantage lies in its ability to deliver tax-free growth from age 70½, the longer you can afford to forego withdrawals, "the more converting plays to your advantage," says Aimee DeCamillo, head of personal retirement solutions at Merrill Lynch Wealth Management.

Before pulling the trigger, speak to a financial adviser. You also can crunch the numbers using online calculators at sites including RothRetirement.com and Fidelity.com/rothevaluator.

Maximize the Benefit
If you determine that it pays to convert, the following strategies can help you maximize the benefit:

Financial experts say it's ideal to have money to pay the taxes due upon conversion from a source other than your IRA. That allows you to retain a bigger sum in your tax-sheltered retirement plan.

Keep in mind that you don't have to convert your entire IRA. It might make sense to do it piecemeal, as you can afford it, over a number of years.

Put converted holdings into a new account, rather than an existing Roth. That way, if the value falls after you've paid the tax bill, you can change your mind, "recharacterize" the account (meaning you move the money back into a traditional IRA) and wipe out your income-tax liability.

You have until Oct. 15 of the year following the year of conversion to recharacterize. For example, if you were to convert your IRA to a Roth in 2010, you would have until Oct. 15, 2011 to recharacterize it. Later on, you could choose to convert the assets to a Roth again.

Better still: Consider opening a separate Roth for each type of investment you hold. That way, you can recharacterize the ones that perform poorly and leave the winners alone.

Write to Anne Tergesen at anne.tergesen@wsj.com

Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved

New Rules - Should You Convert to Roth IRA? (WSJ Encore)

JUNE 20, 2009 Making a Good Deal for Retirement Even Better
New tax rules are about to give more people access to a Roth IRA, one of the best savings plans for later life. Here’s how the changes work—and how to get ready.
By KELLY GREENE
Robert Woods has been “chomping at the bit,” he says, to open a Roth individual retirement account. Next year, the 54-year-old American Airlines pilot finally will get the chance.

Starting Jan. 1, the income limits that have prevented many individuals, including Mr. Woods, from converting a traditional IRA or employer-sponsored retirement plan to a Roth will be eliminated. The change—one of the biggest and most important on the IRA landscape in years—will widen the entryway to one of the best deals in retirement planning. With a Roth IRA, virtually all income growth and withdrawals are tax-free.


The new rules come at a time when many IRAs have plummeted in value, meaning the taxes on such conversions (and you do pay taxes when you convert) will likely be lower, as well. And with taxes at all levels expected to rise in coming years, the idea of an account that’s safe from tax increases appeals to many people heading into retirement.

“It’s potentially quite a big deal,” says Joel Dickson, a principal with Vanguard Group in Valley Forge, Pa. “We’re getting a lot of questions, and investors certainly should be thinking about it.”

Here’s a look at how the new rules work, how to take advantage of them—and the possible pitfalls.

Nuts and Bolts
At the moment, many people make too much money to use Roths. Individuals whose modified adjusted gross income for 2009 is $120,000 or more can’t contribute. For couples who file joint tax returns, the cutoff is $176,000.

You aren’t allowed to convert traditional IRA assets to a Roth if your household’s modified adjusted gross income exceeds $100,000. A married person who files a separate tax return is prohibited from converting—no matter how much or how little he or she makes, says Ed Slott, an IRA consultant in Rockville Centre, N.Y.

But while the income limits for funding a Roth will remain, the rules for conversions are about to change.



As part of the Tax Increase Prevention and Reconciliation Act enacted in 2006, the federal government is eliminating permanently, starting Jan. 1, the $100,000 income limit for Roth conversions, as well as the restriction on spouses who file separate tax returns. That should make it easier for people with higher incomes to invest through Roth accounts. The changes also should enable more retirees—who rolled over their holdings from 401(k)s and other workplace savings plans into IRAs—to convert to Roths.

Of course, there’s still the matter of taxes. When you convert assets from a traditional IRA or workplace plan to a Roth, you have to pay income tax on all pretax contributions and earnings included in the amount you convert.

The law does provide some wiggle room, however: You can report the amount you convert in 2010 on your tax return for that year. Or, you can spread the amount converted equally across your 2011 and 2012 tax returns, paying any resulting tax in those years. For example, if you convert $50,000 next year and choose not to declare the conversion on your 2010 return, you must declare $25,000 on your tax return for 2011 and $25,000 on you return for 2012. The two-year option is a one-time offer for 2010 conversions.

The fact that Uncle Sam is allowing you to stretch out your tax bill could help people who convert keep their nest eggs intact. Financial planners uniformly say it makes no sense to convert to a Roth unless you can pay the taxes from a source other than your IRA. If you need to tap your IRA for the tax money, you’re defeating, in part, the purpose of the conversion: to maximize the long-term value of the Roth.

One other note: If you are age 70½ or older and taking required minimum distributions from a traditional IRA or workplace plan, you can’t convert that required withdrawal to a Roth. However, after you take your required minimum distribution for the year, you can convert remaining traditional IRA assets to a Roth. For 2009, Congress has waived required withdrawals in an attempt to help retirees rebuild savings. But required withdrawals resume in 2010.

So, if you’re over the income limits for contributing to a Roth, what’s the simplest way to fund one when the conversion rules change? If you haven’t already done so, open a traditional IRA (which has no income limits), contribute the maximum amount allowable ($6,000 in 2009 for individuals age 50 and older), and convert the assets to a Roth next year.

John Blanchard, a 41-year-old executive recruiter in Des Moines, Iowa, has “maxed out” IRA contributions for himself and his wife since 2006 in anticipation of the 2010 rule change. He plans to convert about $34,000 in holdings next year. “If they would let me do more, I would do more,” he says. “This planning is purely for retirement.”

You could continue this strategy each year after that—opening a traditional IRA and converting it to a Roth. In fact, you would have to use this approach if your income exceeds the limits for making Roth contributions.

But how do you do this—over a number of years—without winding up with multiple Roth accounts? Mr. Slott recommends holding two Roths. When you first convert the assets, put them in your “new” Roth. That way, if that holding suffers a loss in the first year, you can recharacterize it as a traditional IRA so you don’t have to pay tax on value that no longer exists. (More on that below.) If the account increases in value before that deadline expires, you could then transfer the assets to your “old” Roth—after the time to recharacterize expires. Each year, you could repeat those two steps.

Why It’s a Good Idea…Why convert? Roth IRAs have several big advantages over traditional IRAs:

For the most part, withdrawals are tax-free, as long as you meet rules for minimum holding periods. Specifically, you have to hold a Roth IRA for five years and be at least age 59½ for withdrawals to be tax-free. Early withdrawals are subject to penalties.

There are no required distributions. With traditional IRAs, you must begin tapping your account after reaching age 70½. In doing so, you increase your taxable income starting in your 70s.

Your heirs don’t owe income tax on withdrawals. That can be a big deal for middle-aged beneficiaries earning big paychecks. One caveat: Roth beneficiaries do have to take distributions across their life expectancies, and Roth assets are still included in an estate’s value.

The fact that anyone who inherits a Roth could make withdrawals with no income tax has led some older adults to consider Roth conversions as an alternative to life insurance. Jonathan Mazur, a financial planner in Dallas, already has suggested that strategy to Shayne Keller, a 55-year-old semi-retired telecommunications consultant. Mr. Keller’s heart disease has made it tough for him to get life insurance. Instead, he’s now planning to convert a traditional IRA worth about $300,000 to a Roth, and then name his two grandchildren as the Roth’s beneficiaries.

Another big advantage: A Roth IRA provides what many financial planners refer to as tax diversification.

“In the future, when you’re going to be taking assets out of your account, you don’t know what your personal situation is going to be, and you don’t know what tax rates are going to be,” says Sean Cunniff, a research director in the brokerage and wealth-management service at TowerGroupin Needham, Mass. “So, if you already have a taxable account, like a brokerage account or mutual funds, and you have a tax-deferred account like a 401(k) or traditional IRA, adding a tax-free account gives you the most flexibility” to keep taxes low in retirement.

…And Why It’s Not as Easy as It Looks
The trickiest part of paying the tax for a Roth conversion involves the IRS’s pro-rata rule. In short, you can’t cherry-pick which assets you wish to convert.

Let’s say you have a rollover IRA (from an employer’s 401(k) plan) with a balance of $200,000, and an IRA with $50,000. The latter contains $40,000 in nondeductible contributions made over a number of years. As much as you might wish, you can’t convert the $40,000 alone—tax-free—to a Roth IRA.

Rather, you have to follow the pro-rata rule. The IRS says you must first add the balance in all your IRAs—in this case, $250,000. Then you divide nondeductible contributions by that balance: $40,000 divided by $250,000. This gives you the percentage—16%, in our example—of any conversion that’s tax-free. So, let’s say you want to convert $30,000 of your two IRAs to a Roth. The amount of the conversion that would be tax-free would be $4,800 ($30,000 x 0.16).



“If you’re thinking about doing a Roth conversion, leave your 401(k) alone” rather than rolling it into an IRA beforehand to keep your share of nondeductible contributions higher in the calculation above, says John Carl, president of the Retirement Learning Center LLC in New York, which works with investment advisers. And if you’ve already rolled over your 401(k) into a traditional IRA, you may want to roll it back—a move that many employer plans allow, he adds.

Perhaps the toughest part of all this is “gathering the data”—showing which of your past IRA contributions were deductible and nondeductible, says Kevin Heyman, a certified financial planner in Newport News, Va. “You have to keep one heck of a record to know which IRAs were nondeductible over the years.”It’s involved, but possible, to reconstruct your after-tax basis in a traditional IRA, and it makes sense to do it now so you can weigh whether to convert to a Roth in 2010, says Mr. Slott, the IRA consultant.

First stop: tax returns you still have. You’re supposed to keep a running record of nondeductible IRA contributions on IRS Form 8606 and file it with your tax return. If you haven’t done so, you can either buy back your old tax returns from the IRS, using Form 4506, or you can order a free transcript of everything that’s reported about you to the IRS, using Form 4506-T. Included in your transcript is information from IRS Form 5498, which reports contributions you made to an IRA. Other resources are year-end statements from your IRA custodian.

As mentioned above, you should be able to pay any tax involved from a source other than the IRA itself to make the conversion worthwhile. Some retirees already are setting up piggy banks for that purpose. “I’m putting my savings plan together so we have money to pay for the tax,” says Marjorie Hagen, 60, a retired postmaster in Minneapolis. She and her husband plan to convert at least $150,000 in IRA assets next year to give them “more control and flexibility,” she says.

An IRA withdrawal made simply to pay taxes on a Roth conversion could be a particularly bad move for battered investments because you’d be locking in losses. And if you’re under age 59½, you would get dinged with a 10% penalty for withdrawing IRA assets at the time of the conversion. The silver lining, of course, is that those battered investments probably would be taxed at relatively low value, meaning any tax you have to pay should be relatively low, as well.

Indeed, tax rates—what you’re paying now and what you might pay in the future—invariably complicate decisions about whether to convert. Linda Duessel, a market strategist at Federated Investors Inc., an investment-management firm in Pittsburgh, points out that the income tax you pay on a Roth conversion while you’re working would be at your top rate, since it’s added to your regular income. But in retirement, when IRA distributions presumably would help take the place of a paycheck, you’d be paying tax at your “effective” rate, or the total tax you pay divided by your taxable income.

If you expect your income to be lower in retirement—and tax rates to stay about where they are—then a Roth conversion might not make sense. The upshot: Whether you convert or not basically depends on what you expect to happen with your income in retirement, compared with your income while working, and whether you’re more comfortable paying taxes sooner at current rates or betting on lower taxes later.
Strategies to Consider
What’s the best way to take advantage of the rule change? First, keep in mind that you don’t have to convert your entire IRA next year. You can do it piecemeal, as you can afford it, over a number of years. A Roth conversion “isn’t an all-or-nothing option,” says TowerGroup’s Mr. Cunniff. If you hold traditional IRAs made up largely of pretax contributions, such as a 401(k) rollover, your tax bill could be steep. One way to mitigate the tax-bill pain is to get your accountant to help you figure out how much you could convert within your current tax bracket each year without bumping yourself into a higher one.

It’s also a good idea to put converted holdings in a new account, rather than an existing Roth. Here’s why: If the value of your converted assets falls further—after you have paid taxes on their value—you can change your mind, “recharacterize” the account as a traditional IRA, and, in turn, no longer owe the tax. Later on, you could reconvert the assets to a Roth again. (See IRS Publication 590 for the timing details.) This dilutes the tax benefit if you’ve combined those converted assets with other Roth holdings that have appreciated in value.

In fact, you might consider opening a separate Roth for each type of investment you make with the converted money. That way, you could “cherry-pick the losers,” recharacterizing investments that perform poorly, suggests Mr. Slott. Let’s say you made two types of investments—one that doubled in value and another that lost everything. If those investments were in the same Roth, the account value would appear unchanged. But if they were in separate accounts, you could recharacterize the one that suffered—and allow the one doing well to continue appreciating in value as a Roth.

Some owners of IRAs that hold variable annuities with depressed account values are planning to convert those investments to Roth IRAs as well. The current value of the underlying investments in their variable annuities has fallen below their income benefit or death benefit. In that situation, if you convert to a Roth, you’d pay tax on the lower account value—and potentially get a higher benefit in the future tax-free.

Still, if you have a variable annuity and you’re considering a Roth conversion, make sure you value the account according to the latest IRS rules, Mr. Slott cautions. The IRS cracked down on annuity holders using “artificially deflated” variable-annuity values in Roth conversions a few years ago to lower their taxes, he says. “The IRS ruled that you have to get the actual fair-market value of the account from the insurance company and use that number.”

What You Should Do Now
There are a few ways to get ready for next year. Again, as noted above, if you have money to invest, consider funding an IRA before Dec. 31. That way, you can convert those assets to a Roth as soon as Jan. 2.

Also locate and organize your paperwork for any nondeductible IRA contributions you’ve made in the past. By taking that step, you should be able to come up with an estimate of how much of your potential conversion would be taxable. If you expect your 2010 income to be similar to this year’s, you can look up the tax brackets at www.irs.gov to get a ballpark idea of the taxes involved.

Next comes the tough part: Identifying ways to pay those taxes with money outside of your IRA.

To think through all the moving parts, it may help to consult a financial planner or accountant who has extensive experience working with retirees relying on IRAs. The tax rules governing IRAs are intricate, nonintuitive, and arcane. One misstep can unwind a tax-deferred nest egg in a way you might not have intended.
For example, if you’re already taking regular, so-called 72(t) retirement payments, which allow IRA holders to make “substantially equal” withdrawals penalty-free before age 59½, converting that IRA to a Roth is even trickier, Mr. Slott says. The new Roth can contain no other Roth IRA assets, and the 72(t) payments must be continued from the Roth—but no 72(t) payments from the traditional IRA can be converted to the Roth. And if you have company stock in your 401(k), you might wind up with a lower tax bill if you withdraw the stock from the account before doing an IRA rollover and Roth conversion, he adds.

Seek out online tools to help you devise your conversion strategy as well. One resource is Mr. Slott’s Web site, www.irahelp.com, which has a discussion forum where consumers can post questions about Roth IRA conversions and get answers from investment advisers who specialize in IRA distribution work.

At least one free, interactive calculator has been developed to help people think through the decision. Convergent Retirement Plan Solutions LLC, a retirement-services consulting firm in Brainerd, Minn., released a Roth Conversion Optimizer calculator in May for investment advisers with Archimedes Systems Inc., a Waltham, Mass., maker of financial-planning software. A consumer version of the calculator is available at www.RothRetirement.com.

“For the vast majority of middle America, the question is, ‘What’s the best portion of my IRA to put into a Roth?”’ says Ben Norquist, president of Convergent.

The calculator takes several factors into account, including your income needs from retirement assets, future tax rates and the portion of your assets you convert to a Roth. Then, it crunches those variables to show you, using a simple bar graph, the impact of a Roth conversion on your future assets.

One caveat: With any calculator that lets you adjust the future tax rate, as this one does, it’s easy to manipulate the answer if you’re predisposed to doing a conversion now—or avoiding it because you don’t want to pay the resulting tax bill, Mr. Slott says.

Still, the calculator does help you pin down the answer to the big question you should answer for yourself this year, Mr. Norquist says: “If I can take a portion of my assets and shift them over to a Roth, am I going to sleep better knowing they can’t be touched by future tax increases?” If your answer is “yes,” it’s time to start digging out records and number-crunching.

--Ms. Greene is a staff reporter for The Wall Street Journal in New York. She can be reached at encore@wsj.com.