The client’s advisor is incorrect about the basic premise, and there are two issues to be clarified:

1) When a rechacterization is ordered using a dollar amount of % of the original conversion, the earnings calculation must include all the assets in the Roth account holding the conversion, not just the investment that is chosen to be sent back to the TIRA.
2) Once the earnings adjusted dollar amount has been calculated, the client can choose any investment they wish to be sent back to the TIRA, as long as the value equals the calculation done in 1) above.

Therefore, the strategy of cherry picking recharacterizations is seriously diluted if separate conversions to different Roth accounts are not done.

If 50,000 of stock A and 50,000 of stock B are converted to the same Roth, and if A increases to 75,000 while B declines to 25,000, the total Roth value remains at 100,000.
If the client then decides to recharacterize all of the B shares only, he is recharacterizing 25,000 or 25% of the original conversion. 75,000 remains taxable and 75,000 remains in the Roth.

Contrast the above with converting A and B to different Roth accounts. Client decides to recharacterize only the Roth holding the B shares. In this case, the taxable amount of the remaining conversion is 50,000 and the remaining Roth is worth 75,000.

The remaining Roth is worth the same 75,000 in either case, and 25,000 goes back to the TIRA in either case, BUT the tax bill for the first scenario is 50% more than the second, and this wipes out the value of the cherry picking strategy since separate Roths were not used.

• Flag as spam
• Log in to Reply

Jerry,

1) If you recharacterize half of the 230k conversion, you will only report half of the original 230k conversion amount, not half of the value at the time of the recharacterization.

2) If your only conversion was the 230k, that Roth would have to grow to 383,334 for the effective tax on this conversion to be reduced from 25% to 15%. You are correct that if you recharacterized half of this conversion you would be left with a Roth worth 191,667 and you would owe tax @ 25% of 115,000. You need gains of 66.7% in the Roth to reduce your effective tax rate to 15%. Your current gain of 20% creates an effective tax rate on this conversion of 20.8%.

If you are going to recharacterize any of the 3 conversions, you should start with the accounts with losses, then move to the ones with the lowest gains. That would mean that you would recharacterize the smaller conversions first if they grew less than the large one. You would also plan to wait until Sept, 2011 to recharacterize, unless you wanted to bank the gains you had and change the investments to something much more conservative. If you did that, you could recharacterize sooner, maybe even by the end of March so you could file a final 2010 return on time.

If you expect your tax rate to be higher after 2010, you are correct to opt out of the two year deferral. But if you have large gains in one of the conversions, you might consider retaining a total conversion of more than 115,000, which is your target without gains, as long as you have the money to pay the additional taxes. But if you do not want to pay any more than 15% effective tax, you need 67% gains; if you want to pay no more than 20%, you need a 25% gain. No gain is where the actual tax and the effective tax are the same, ie 25%. If you have losses, then the effective tax increases over 25%, and then you might want to recharacterize all of it and try again next year. Or you might just want to do several years of smaller conversions just to the top of your actual bracket for that year. since it sounds like you expect your future tax rate to decline. You might also want to wait and see about a VAT or national sales tax, which would reduce the value of your conversions relative to sticking with the TIRA.

Remember, that after you recharacterize, the remaining Roth funds will continue to gain or lose, so the value at the actual recharacterization date is just a temporary snap shot of your effective rate at that time and further changes can quickly increase or decrease that effective rate.

• Flag as spam
• Log in to Reply

1) I agree that you should avoid paying more than 25%, and recharacterizing all but the 115k with the largest gain will result in your Roth values exceeding your TIRA values. That is a solid baseline breakdown between the two. Additional conversions should be limited to amounts that you can either do at a lower rate OR conversions that produce large enough gains to reduce the effective tax rate below 25%. You might do these additional conversions incrementally over the next 4 years before SS kicks in at 70 and you have to factor in the effective rate of tax on the SS benefit. Sounds like you will probably have to include 85% of SS in your AGI or close to that, so you would probably wind up the conversions before filing for SS. You did not mention state income tax, so I assume you are not in one of the highest tax states.

Your options can be influenced by your willingness to go through the recharacterization and reporting process. If you have an appetite for that, you could continue to over convert over the next 4 years to see if you can generate a large gainer, and if not just recharacterize all of them. Pretty much the same as you are doing this year, but since you will already have over half in Roth after this year, the next 4 years would be more selective situations where you would retain only the conversion amounts that produce enough earnings. Recharacterizations are one of the few tax strategies where you can apply total hindsight, figure your taxes in March or April with only the amount of the outstanding conversions subject to change. You would therefore know the exact cost of each conversion dollar.

Good point on the LTC situation – if you and spouse does not have broad LTC insurance, your target amount to convert would be less than otherwise, but is factored into the above. Same if you expect a variety of VAT to pass.

2) Yes, I think I would ignore it since it is quite a ways away, and RMDs for the TIRA piece get fairly high past the mid eighties. Plus, without a VAT, income tax rates will probably rise. Also, remember that filing single will increase the marginal tax rate unless income drops in proportion, and it probably won’t.

3) Not sure what you mean here about a loss. If a Roth conversion has more than minimum losses, you would probably recharacterize that entire conversion. The reduced value of that conversion would migrate back to the TIRA, and there would be no current tax impact other than going through the reporting process. It would net out just as if you never converted in the first place, and the loss took place in the TIRA. You could not deduct the loss anywhere on your tax return since there has been no distribution.

Of course, there is always the risk of unintended consequences, so all these plans are still subject to some luck of the draw. But doing the planning you are doing certainly moves the odds in your favor.

• Flag as spam
• Log in to Reply

A forum such as this is useful for providing general information, but not specific legal advice. The following is intended to provide some things for you to discuss with your lawyer, whom you said you would be seeing in a few weeks.

You have a choice between converting up to the top of the 15% bracket or up to the top of the 25% bracket (or, perhaps, up to the top of the 28% bracket). There is a tradeoff between converting more quickly and going into a higher bracket, or converting more slowly and staying in a lower bracket.

You may want to create a spreadsheet comparing these choices. You’ll have to make some reasonable assumptions as to future income and estate tax rates, investment returns both within the IRA and after-tax outside the IRA, how long you and your wife will live, and how long your children (or other beneficiaries) will live following the deaths of you and your wife.

There are some miscellaneous factors that will affect the income tax, including the various phaseouts, the alternative minimum tax (AMT), Medicare Part B premiums, the 3.8% Medicare tax beginning in 2013, and state income taxes. If you leave your retirement benefits to your chldren (or other beneficiaries) in trust rather than outright (something you may wish to discuss with your lawyer given the amount involved.

• Flag as spam
• Log in to Reply

You are correct that to the extent tax rate on the distributions would be significantly lower than the tax rate on the conversion, then you would be be better off not converting. You are generally better off converting to the extent the tax rate on the conversion is less than, the same as, or not “too much higher than” the tax rate on the distributions (but for the conversion).

We generally have our clients provide for their children in trust rather than outright, assuming the amount involved is sufficient to warrant administering a trust. Inheritances in trust are better protected against the child’s potential creditors (including spouses), and will not be included in the child’s estate. While there are some complexities involved in leaving an IRA in trust (none of the IRA benefits accumulated in the trust can ever go to anyone older than the person whose life expectancy you want to use to measure the required distributions), the same reasons for leaving other assets in trust apply to IRA benefits. For more on this, see my article on trusts as beneficiaries of retirement benefits in the March 2004 issue of BNA Tax Management’s Estates, Gifts & Trusts Journal: http://www.kkwc.com/docs/AR20041209132954.pdf .

One of the tradeoffs with leaving a traditional IRA in trust is that trusts reach the top income tax bracket at a low level of income, so that the trustees have to choose between making distributions to save income taxes or accumulating the assets in the trust to keep them out of the beneficiaries’ estates and maintain the asset protection. The Roth conversion avoids that tradeoff.

• Flag as spam
• Log in to Reply