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Thomas Harwood: Ways to create or convert to a Roth IRA

It's The Law

Posted: July 9, 2009 5:40 p.m.
Updated: July 10, 2009 4:55 a.m.
The Roth IRA is a generous tax avoidance vehicle. Unlike other qualified retirement plans, the Roth does not require distributions once the owner reaches age 70 1/2.  Roth IRA money can be left to grow tax free not only for the life of the owner but also stretched based on the age of nonspouse beneficiaries. Many people balk at the idea of paying income tax now rather than it being deferred. They fail to consider that this money can grow tax-free for generations and withdrawals from a Roth IRA are income tax free. Moreover, it’s often cheaper to pay the income tax than if paid as estate taxes. This article discusses ways to create or convert to a Roth IRA.

IRA Conversions
Although annual contributions to an IRA are limited, it is often prudent to “rollover” an old 401(k) or other qualified account to an IRA.

Therefore, an IRA can be a person’s largest asset.

A traditional IRA can be converted to a Roth IRA subject to IRS regulations and with recent law changes a qualified plan may be directly converted to a Roth IRA.  Income taxes have to be paid and this is best done with money outside of the IRA for maximum longterm benefit.  There is currently an income limitation that may prevent the conversion, which is being eliminated beginning in 2010.

Conversions must be completed by Dec. 31 of the tax year. This can be confusing for people who don’t know their income tax computations until after the tax year has ended. IRS regulations simplify this decision by employing a concept called recharacterization.

Recharacterization allows a person to reverse or undo a Roth IRA conversion and can be done up to October 15 of the following year, essentially allowing more than nine months to undo a conversion.  If recharacterization is employed, the taxes paid for the conversion are no longer owed. This may require an amended tax return to get the refund.

A recharacterization can be done for any reason. One good reason is when the account value declined after the conversion and taxes were paid on the higher value. Another is where income levels would result in a penalty. Even a decedent can recharacterize if otherwise eligible.

A simple conversion moves all assets from the traditional to the Roth.  A more creative approach involves moving individual investments from the traditional IRA to separate newly created Roth IRAs.  For the latter, if the value of one investment goes down while the other goes up, you might recharacterize the loser while keeping the appreciated investment in its separate Roth account. 

Without separate Roth IRAs, a partial recharacterization would be required, on a pro rata basis, resulting in only a minimal tax reduction.

IRS regulations and rulings are continually changing and can be complicated.  Estate planning should include Roth IRAs. Overlooking this often sizeable asset can result in an unnecessarily large estate tax burden.  IRAs need individualized estate planning considerations to minimize taxes and provide long term benefits to beneficiaries. Don’t assume your estate plan is enough to avoid unnecessary taxes.

Stretching an IRA is a strategy designed to prolong or “stretch” the period of time over which earnings can be tax deferred.  It is used when an investor does not need all of the funds from the retirement account, and wishes to create an estate that can extend for generations. Beneficiaries will still need to take minimum distributions.

As each individual’s tax situation is different, take time to consider all the facts and consult with your tax advisor before initiating a rollover. This information is not intended to be a substitute for specific individualized tax, legal or estate planning advice.

Thomas M. Harwood is an attorney and Chartered Financial Consultant (securities and investment advisory services offered through SagePoint Financial, Inc., member FINRA/SIPC and a registered investment adviser.)  He can be reached at (661) 272-4282.  “It’s the Law” appears Fridays and rotates  between members of the Santa Clarita Valley Bar Association:  Nothing contained herein shall be or is intended to be construed as providing legal advise. His column represents his own views and not necessarily those of The Signal.


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