Pre and After Tax IRA's Conversions are HOT!

Roth conversions are really hot right now and we've gotten lots of clients, many high wealth, asking about converting both pre-tax and after-tax IRA's into Roth's. The first thing we need to do is to make sure we're starting from the same page with a couple of definitions as we use them:

1. - Pre-tax: A pre-tax IRA represents an IRA funded with dollars that were either a part of a payroll filing or from wages or were deducted on a tax return. In either case your Annual Gross Income (AGI) was reduced for the contribution. You therefore have no tax basis in these dollars and when you do anything with them you must pay ordinary income taxes on them.
2. - After-tax: An after tax contribution to an IRA represents contributions you've made to IRA accounts that were not deducted on your income tax return or were not a part of your payroll. These funds have already been taxed and therefore the basis of these accounts is tax free on any withdrawal.

The science of the deal:

• - Pre-tax: Because all of the regular income tax must be paid up-front, the math tells us that some clients will never re-gain portfolio value, for that opportunity cost lost by paying all of the tax up-front.
• - After-tax: A lot of after tax IRA accounts are actually below their principal value and a conversion to a Roth may not actually result in much or any ordinary income to be taxed. Depending on the amount of gain over the original principal contributed these After-tax IRA's represent a great opportunity for converting to Roth's, unless you do not have an active 401(k) plan.
• - Active Plan's: If you've already rolled your active 401(k) plan to an IRA then the weighted average tax basis of your entire IRA (both pre and after tax) is used when converting After-tax IRA's to Roth's and now the science of an After-tax conversion is more akin to the Pre-tax conversion.

Planning point: If you are rolling After-tax IRA's to a Roth and you are still contributing to an active 410(k) plan, roll the 401(k) plan's from other employment periods into your current account. Now when you convert your After-tax to a Roth you won't have any weighting between the two plans.

The art of the deal:

• - The "Post 62 mind warp": Several years-ago a client and I were discussing these Roth conversions in detail and he mentioned that he experienced a mind-change event that I affectionately call "the Post 62 Mind Warp". I discuss it often during my public speaking engagements at regional meetings etc. This phenomenon relates to changes in thinking that historically occur sometime between ages 62 and 65 when people are determined to take funds from whatever portfolio they have that does not result in income to be taxed. This phenomenon is the reason there is a Required Minimum Distribution (RMD). People reach the age when they should be taking funds out of these accounts and they aren't because they don't want to be taxed. As my client pointed out, by the time most people reach this age, they've forgotten the amount of tax they've paid into the IRS in advance, but they love the fact that they don't have to pay tax when they take money out of their Roth.
• - RMD: Roth withdrawals' do not count toward the RMD. If all of your IRA's are Roth's then you have no RMD.
• - Gifts: Gifts made directly to a qualified institution from an IRA (non-Roth) count toward the RMD.
• - Estate planning: Giving a smaller Roth to the next generation may not carry the same value as transferring a larger IRA to the next generation if it's assumed the next generation is in a low tax bracket.

Planning Questions:

Converting all of the IRA to a Roth will result in state and Federal income taxes of about 41% in total, so what makes you comfortable? How does the Roth/IRA fit into your estate and gifting plan? Are you experiencing the Mind Warp?

Conclusion: Income taxes are going higher and will more than likely stay higher for the next six years. If you're going to be using substantial portions of your IRA account for living or planning or gifting over the next six years, then converting that amount now makes a great deal of sense. Converting more than that amount doesn't "calculate" but it still comes down to how you'll feel about having most of your retirement not subject to tax.

Coin flip anyone?

Everyone's circumstance is different and I haven't answered all of the possible questions, but I hope I've at least provided more information so as to help you make the decision that's right for you.

Let me know.

Bill.

R. William E. Kruse III

"Above all, we must realize that no arsenal, or no weapon in the arsenals of the world, is so formidable as the will and moral courage of free men and women. It is a weapon our adversaries in today's world do not have."

Ronald Reagan

Hauk Kruse & Associates LLC
721 Emerson Road; Suite 120
Creve Coeur, MO 63141
314.993.4285 (w)