Private Client Services Update – Three Roth Conversion Planning Opportunities

    By David Kamer, Estate, Trust & Wealth Transfer

    Beginning in 2010, the current income limit on conversions from a traditional IRA to a Roth will be lifted, allowing high-income taxpayers to take advantage of this powerful tax-planning vehicle for the first time. While a Roth conversion may not appeal to all taxpayers, here are three situations where conversion might be particularly attractive.

    1. Charitable Giving. Individuals who are planning charitable gifts in the coming years might consider accelerating those gifts into the 2010 taxable year in order to offset taxes triggered by a Roth conversion. Normally, a Roth conversion triggers income tax at combined state and federal rates of approximately 40% of the value of the converted IRA. If the taxpayer makes charitable donations equal to the value of the converted IRA in the same year, this could reduce the income tax hit to 20% of the converted IRA value. For the charitably inclined, it might be an opportune time to add a Roth conversion to the mix.

    For Roth conversions done in 2010, a one-time rule allows the taxable income to be spread over two years, so charitable gifts in this instance could be made half in 2010 and half in 2011 to offset the Roth conversion taxes.

    2. The Roth Mulligan. In a time of market uncertainty, some individuals may be concerned that they will pay taxes on a Roth conversion only to have the underlying investments lose value, in which case they would have been better off leaving the assets in a traditional IRA. Fortunately for taxpayers, the Roth conversion rules include a liberal “recharacterization” option that allows taxpayers to “undo” Roth conversions by October 15th of the following year. This recharacterization opportunity applies separately to each Roth IRA established by an individual.

    These rules allow taxpayers to effectively take a “mulligan” on any Roth investments that perform poorly out of the gate. For instance, consider a taxpayer who converts a traditional IRA to a Roth IRA in 2010 and invests the proceeds in three different mutual funds. If the individual establishes three different Roth IRAs, one for each of the three mutual funds, he will then have until October 15, 2011 (assuming that the taxpayer duly extends his tax return filing date) to decide which of the Roths to keep and which to scrap. Any funds that have gained in value since the conversion date can remain in the Roth account. Any funds that have lost value can be recharacterized as a traditional IRA, with the result that the taxpayer no longer owes taxes in connection with the Roth conversion and is further entitled to a refund of any taxes previously paid on the conversion. Better yet, any IRAs recharacterized in this manner can again be converted to Roths in future taxable years, with yet another chance to recharacterize if the underlying investments perform poorly by the recharacterization deadline.

    3. The Roth Business Ownership Plan. In a previous client alert, we outlined the Roth Business Ownership Plan or “Roth BOP,” a strategy that allows an individual to use assets held in a Roth account to purchase a closely held business. A recent decision by the Tax Court (Taproot Administrative Services, Inc., 133 T.C. 9) confirmed the viability of this approach, ruling that a Roth IRA may be a majority shareholder of a corporation controlled by an individual provided that the corporation is a “C” corporation and not an “S” corporation. This ruling, while not surprising, reaffirms the usefulness of the Roth BOP for an individual who wishes to purchase a business using funds held in a Roth account.

    Shad C. Fagerland is a partner in the firm’s Williamsburg office, where his practice focuses on qualified and nonqualified retirement plans. Shad can be reached at (757) 259.3828 or David Kamer is a partner in the firm’s Norfolk office, where he maintains a trusts & estates practice with particular focus on professionals and executives and non-profit organizations. David can be reached at (757) 624.3175 or

    The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances. Copyright 2024.