case study

Case Study

Determining Whether a Taxpayer Might Benefit from a Roth IRA Conversion

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King and Nordlinger, L.L.P.
Arlington, VA

Editor's note: This case study has been adapted from "Guide to Tax Planning For Individuals," 4th Edition, by Anthony De Chellis, Douglas L. Weinbrenner, Catherine A. Roeder and James F. Reeves, published by Practitioners Publishing Company, Fort Worth, Tex. 1999.

Facts: Harry Headache, a long-time client, seeks his tax adviser's counsel as to whether to convert the $125,000 balance in his regular IRA to a Roth IRA. Harry is married to Greta; both are age 63. Their joint 2000 modified adjusted gross income (MAGI) will be approximately $78,000. The following is a checklist of factors the tax adviser should consider when talking to Harry about conversion.

Taxpayer:

_______________________________________

Tax Year:

___________________

Prepared by:

________________________

Reviewed by:

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Purpose of this checklist: This checklist can be used as a review of the factors of a given client situation to help determine whether the taxpayer might benefit from a Roth IRA conversion. Questions with a "yes" response generally indicate a factor in favor of a Roth conversion. A "no" response normally indicates a potential problem with a conversion.

	Yes	No	N/A
1. Will the taxpayer's joint MAGI be $100,000 or less in the year of the conversion? (If no, a conversion is not allowed.)	–––	–––	–––
2. If married, are the taxpayers filing a joint return for the year of the conversion? (If no, a conversion is not allowed.)	–––	–––	–––
3. Does the taxpayer understand the Roth IRA withdrawal provisions (e.g., five-year holding period, exceptions to early withholding penalties, etc.) as they relate to rollover (conversion) accounts?	–––	–––	–––
4. Will the taxpayer's income or estate tax planning, or both, benefit from not having to take minimum distributions from the IRA beginning at age 701/2? A taxpayer is not required to take distributions from a Roth IRA at a certain age; the pre-death minimum distribution rules for traditional IRAs do not apply.	–––	–––	–––
5. Would the taxpayer benefit from the ability to name new beneficiaries of the IRAs after age 701/2? April 1 of the year after a taxpayer turns age 701/2 is the deadline for selecting beneficiaries that will have a positive effect on the minimum distributions the taxpayer is required to take from a traditional IRA. Under a traditional IRA, after this date, a taxpayer can still change beneficiaries, but the new beneficiary will be ignored for purposes of the minimum distribution rules, unless he is older than the previous beneficiary (in which case, the life expectancy of the new beneficiary will cause the taxpayer's required minimum distribution to increase). Because the minimum distribution rules do not apply to a Roth IRA until the IRA owner's death, the account's beneficiary can be changed at any time (and have an effect on the minimum distributions required after the owner's death), even if it is past April 1 of the year after the owner turns age 701/2.	–––	–––	–––
6. Does the taxpayer want to maximize the amount passed on to heirs?	–––	–––	–––
7. Does the taxpayer have non-IRA funds available to pay the income taxes on a Roth IRA conversion (thus maximizing the IRA funds that can build up tax-free)?	–––	–––	–––
8. Will a conversion have minimal (or no) negative effect on the taxpayer's ability to claim AGI-sensitive deductions, credits or exclusions? For example, because of the additional income caused by a Roth conversion, a taxpayer might not be able to claim such benefits as the child or education tax credits, adoption credit or deduction for interest expense on a loan for higher education expenses. Other items that could be adversely affected by an increase in income include the $25,000 rental exception to the passive loss rules, the personal exemption and general itemized deduction phaseouts, the medical and miscellaneous deductions and the $2,000 regular IRA deduction for individuals covered by a pension plan. In addition, if the taxpayer is receiving Social Security benefits, more of the benefits could be subject to tax.	–––	–––	–––
9. Have the alternative minimum tax (AMT) implications of the conversion been considered? (Because of the increased regular income caused by the conversion, the AMT effect of a conversion should be positive or neutral.)	–––	–––	–––
10. Have the state inheritance tax implications of a conversion been considered? (Because the income tax paid at conversion reduces the taxable estate, the impact should be favorable in a taxable estate or neutral in a nontaxable one.)	–––	–––	–––
11. If the taxpayer's Federal and state estimated income tax (or withholding) payments are not based on a "safe" estimate for the conversion year, has the income triggered by the conversion been considered when determining the need to make or increase estimated tax payments?	–––	–––	–––
12. Do taxpayers who intend to make charitable bequests at death have assets other than the Roth IRA with which to fund the bequests? Unless a traditional IRA is used to fund a pecuniary (fixed dollar) charitable bequest, leaving a traditional IRA to charity allows the IRA owner's estate and beneficiaries to avoid paying income tax related to the IRA. In such a situation, there is no reason to convert to a Roth; the conversion will trigger a tax liability that could be avoided if the charity is simply named the beneficiary of the traditional IRA.	–––	–––	–––
13. Have professionals and others who might be concerned about asset protection issues had their attorneys confirm that the applicable state laws provide protection for the Roth IRA that is at least as good as the protection they provide for traditional IRAs? Because some state statutes refer specifically to Sec. 408 (for traditional IRAs) or otherwise apply only to traditional IRAs, assets in a Roth IRA may not have the same protection against creditors as those inside a traditional IRA.	–––	–––	–––
14. Does the taxpayer anticipate leaving the funds in the Roth IRA for an extended period of time (probably at least 10 to 20 years)? (Without this length of time or more, the benefit of tax-free income generated by the Roth IRA may not offset the detriment of having to pay tax at the time the funds are converted.)	–––	–––	–––
15. When the taxpayer (or his beneficiaries) takes distributions from the Roth IRA, is it likely the person receiving the distributions will be in at least as high a tax bracket as that applied to the taxpayer on conversion?	–––	–––	–––
16. Does the taxpayer have a relatively high basis in existing IRAs (because of nondeductible contributions)? (A higher basis minimizes the amount of income triggered, because of a conversion of funds to a Roth IRA.)	–––	–––	–––
17. Is it likely the taxpayer would not have to pay income tax on Social Security benefits if it were not for the requirement to take minimum required distributions from traditional IRAs?	–––	–––	–––
18. Is it likely that the income from a conversion will not be taxed at a high rate, because of expiring net operating loss carryovers or other carryovers, higher than normal deductions, low cyclical income, etc.?	–––	–––	–––