Home » CEO Life » Taxing Matters

Taxing Matters

New tax rules offer access to a potentially lucrative retirement investment opportunity—converting traditional IRAs into Roths.

It’s no secret that the economy has been suffering, but amidst all the turbulence and wreckage of the past year or so, there’s at least one surprisingly under-reported investment opportunity for highly compensated executives: For the 2010 tax year, there are no income restrictions on conversion of a traditional IRA to a Roth IRA. This allows affluent people previously barred from Roths a potentially beneficial way to use them.

According to James Richardson, senior financial adviser at Raleigh, N.C.-based Richardson, Carrington, Weaver & Associates, a financial advisory practice of Ameriprise, Roth conversions should be weighed as a potentially valuable opportunity. “If all of your retirement savings are in an IRA, for instance, it’s well known how you’ll be paying taxes, starting at 70,” he says. “If your assets are spread out among different types of accounts, you’re protecting yourself from potential changes in tax laws that you can’t control, and it’ll let you pull out your money based on what makes sense at the time.”

Smashed Ceilings

In previous years, anyone with a modified adjusted gross income of $120,000 or more was prevented from converting an IRA into a Roth. For the 2010 tax year, income brackets are essentially irrelevant—anyone can convert an existing IRA into a Roth, with the added benefit of having two years instead of one to pay taxes on to the conversion. Half would be due in 2011, with the balance deferrable until 2012.

This means tax year 2010 represents a unique opportunity for those in the top tax brackets to allow their investments longer to grow, to accumulate income tax-free, and to withdraw it after age 59.5 or after the contribution has been in place for at least five years. That said, there is a wide array of personal and specific considerations to make with the help of a tax accountant or lawyer to help decide whether such a conversion is appropriate for you. But when done for the right reasons—and done the right way—you, your spouse and your heirs can stand to benefit greatly for decades to come.

Conversion Cost

While the opportunity to convert is available to anyone, most experts say the process is only worth considering if you already have liquid assets to pay for the conversion-related taxes out of pocket (as opposed to liquidating retirement assets). If you have the money to pay those taxes, a properly executed conversion can help you to take full advantage of the current tax code and maximize any potential gains, says Steven Wagner, managing director, investments, Private Banking and Investment Group of Merrill Lynch located in Adventura, Fla.

An ideal strategy for converting any traditional IRA into a Roth, says Wagner, is to break the IRA’s portfolio down into new, separate IRA accounts. Each one will be comprised of a unique bucket of distinct asset classes, such as U.S. equities, for example, that have negative correlations to other asset classes, such as foreign currencies. With market volatility affecting different assets classes differently, each of these new, separate accounts will experience taxable gains or losses on their own—rather than cumulatively within a single account.

Hindsight Help

The benefit of this approach is that the taxable value of each account is set on the date you initially convert it. Due to the extended time period for paying conversion-related taxes for 2010, you’ll be able to wait up until October of 2011 to retroactively determine, based on performance, which of the accounts to finalize in the conversion and which ones to shift back to the traditional IRA. This means you can avoid paying taxes on any subsequent performance-related increase up to finalizing your conversion in October of 2011. This will enable you to maximize gains and minimize tax liabilities on those assets that you convert—with the added benefit of sending back underperforming assets (which can be converted in following years, if you so desire).

“You very rarely get to make investment or tax decisions after you know results,” says Wagner. “There are calculators available that show you projections of benefits in today’s valuations, but by breaking your IRA portfolio into buckets and segmenting the volatility, you can look back at actual results when it’s time to pay taxes, which are dramatically different than what the calculator would’ve told you. If you have any inclination, then it behooves you to put strategy in place. It doesn’t cost anything or change your investment decisions, you just let it play out and decide after the fact.”

Process and strategy aside, the conversion represents a compelling opportunity, especially for investors interested in intergenerational wealth building, says Wagner. “The ability to compound the remainder of your IRA free of taxes for your heirs is possibly the most powerful aspect of the conversion,” he says. “For most people in their 50s and 60s, it’s beneficial over their lifetime, but add in the ability to stop having required minimum distributions, and the ability to have assets pass on income tax-free and come out that way. When you run numbers on that, the opportunity is staggering.”

About Michael Gelfand