Six Cautions About Roth IRA Conversion
6. Juggling Annuities and Roth IRAs
This factor is unique to annuities. When a client converts a traditional IRA (existing contract) to a Roth IRA, the owner may pay income tax on an amount greater than the contract value. The contract value plus the actuarial present value of any additional benefits equals the entire interest of the IRA. It is generally appropriate to reflect the value of these additional future benefits (unvested bonuses, income guarantees, etc) in a conversion.
5. The Order of Withdrawal Dilemma
Another way in which withdrawals can be complicated from a tax standpoint is that there is an order of withdrawal from Roth IRAs. All Roth IRAs are aggregated and any withdrawals are deemed to be regular contributions first, conversion contributions next, and earnings last. There are different considerations for each of these categories. (Special rules apply if any of the conversion or rollover was non-taxable at the time of the transaction and if there has been more than one conversion or rollover.)
4. Converting After Tax Gains
Clients can convert after-tax IRAs to Roths without paying taxes, but to calculate taxes, the government aggregates all of a clients IRAs including traditional, SEP and simple IRAs. So if you had one $300,000 IRA holding $100,000 in after-tax contributions and a second IRA holding $200,000, which is all untaxed, these would be combined into $500,000 for tax reporting purposes and for determining the taxable portion of distributions and conversions.
By aggregating the values, 20% the IRA assets are after tax ($100,000/$500,000=20%.) Even if you only convert the first IRA, 80% of its value will be taxable.
3. Changing Retirement Income Needs
One problem of calculating Roth conversions today is the tendency to look at clients in terms of their gross income today. Their income may be different in retirement because theyre no longer paying into Social Security or their 401(k)s for example. In addition, those over age 65 may receive increased deductions and a maximum of 85% of Social Security income is taxed. These factors may result in a lower taxable income and tax bracket in retirement. If thats likely to be the case, clients may do better if they wait to convert after they retire instead of before when their bracket is higher.
2. Potential Penalties for Underpayment
Roth conversions may require estimated tax payments to ensure clients dont get a penalty for underpayment. In 2010, you could take a rollover and spread the income into 2011 and 2012, but you couldnt necessarily just defer the whole first payment to 2011 - and not pay taxes on it until 2012 and then pay taxes on the other half in 2013. Clients are still subject to estimated taxes. Advisors need to work with a good, qualified CPA to ensure clients dont get hit with penalties.
1. Increased Taxable Income
A Roth Conversion is likely to increase taxable income in the following ways: Increased marginal tax rates; increased taxes on Social Security; reduced medical and miscellaneous deductions; reduced exemptions and Schedule A deductions (in 2011 or later); increased Medicare part B premiums (this benefit is means-tested and goes up with a rising adjusted gross income); and a conversion could make clients subject to the AMT.
With tax season upon us, most advisors are looking for ways to help clients maximize their tax savings. But with some converting to Roth IRAs, the folks at Allianz offered some cautions to help navigate rocky conditions.