I received this email reply from the client-
“After reading your response I decided to visit the IRS web site and some others to try to learn more about converting, especially as it applies to an already retired person, and to find out if there is a worksheet to play around with. Boy, I'm sorry I did. I just got more confused than before. I couldn't find anything that pertains to a retired person wanting to convert nor any kind of worksheet to use.
I'm not sure just how much of my IRA's I would like to convert in January, let's say approximately $ 20K. How much would my liability be?
If converting is going to cost the same or nearly the same as leaving it as a Traditional IRA, then I wonder if I'm better off not doing anything. At this point I don't know because I have no way of evaluating the two.”
He also touched on the issue of the “0%” capital gains tax rate.
“Now I remember where I read about the 0% tax on capital gains. It was in YOUR client update newsletter!!! Anyway, perhaps I can look to doing something in the New Year if my AGI and deductions will be such that I can. If I could sell my (XXX shares of XYZ) with no capital gains tax and roll the proceeds into more shares of (ABC), whose dividend yield is much better, then I could greatly increase my annual dividend payout.”
Here is my reply to the client -
It is indeed a confusing subject. Taxes in general are confusing.
The benefit of a ROTH account comes from the tax free accrual of earnings over an extended period of time.
The ROTH is best suited for the taxpayer just starting out in the workforce. Over his/her working life he/she can accumulate $500,000 and upwards in a tax free ROTH retirement account - whether from an IRA or 401(k) (assuming, of course, that Congress doesn’t change things in the future).
Even the middle-aged worker will benefit from ROTH tax-free accrual because of the period of time involved before retirement.
The ROTH option is not usually considered for a retiree because of the lack of continued contributions and the possible limited period of time involved. That is why you could not find much info on the situation in your online search.
Why it is even thought of for a retiree today is because the economic mucking fess has substantially reduced the value of current taxable retirement accounts and short-term future growth is anticipated to be at an accelerated rate as the economy “recovers”.
Partial conversion would also reduce the amount of future required minimum distributions from traditional IRA accounts. This would not be a benefit if you were to receive annual distributions in excess of the statutory minimum from the tables due to cash flow needs (for example your required minimum distribution based on asset value was $20,000 but you withdrew $25,000 annually).
If you were to convert $20,000 of your traditional IRA to a ROTH account you would pay tax now on $20,000, with a minor adjustment for tax basis consideration (recovery of non-deductible contributions), but that $20,000 could grow to $40,000 or more over time and you, and future beneficiaries, would get a net benefit of $20,000+ in totally tax free income.
The problem with conversion is that it increases your Adjusted Gross Income (AGI) – and anything that increases AGI could reduce deductions and credits and increase taxable income elsewhere.
If you would not already be taxed on the maximum 85% of Social Security the conversion would increase your taxable benefits. It would reduce any potential itemized deduction for medical expenses by $1,500 ($20,000 x 7.5%). It would reduce any portion of qualified dividends and long-term capital gains that would be subject to the 0% tax rate (or if repealed 5%), resulting in a 15%, or at least 10%, additional tax on such income – or up to $3,000 in tax on the $20,000 example.
Just as a ROTH conversion would increase your AGI so would capital gains generated to take advantage of the 0% tax rate. While the gains themselves are taxed separately at 0% or 15%, by increasing AGI the amount of the gains could increase taxable Social Security and reduce medical deductions.
Perhaps a ROTH conversion, even a partial one, is not wise, even at this time. The sale of appreciated current assets to take advantage of the 0% tax rate and reinvesting the proceeds in an investment that will generate higher dividends is a good idea. But because of the already higher AGI for 2008 this should be done in 2009.
Before doing anything we would need to review your anticipated AGI, deductions and taxable income for 2009 to see how much capital gain and qualified dividend income would be available for the 0% rate.
I realize your head must be spinning with this “stuff”.