Some predict the rules will never take effect if power in Washington changes.
Affluent clients decidedly benefit from changes
wrought by the Tax Increase Prevention and Reconciliation Act (TIPRA)
signed into law in May, and that's good news for the advisory
profession. But will your practice prosper, or your competitor's?
"Advisors need to talk with clients about the new Roth IRA conversion rule before someone else does, or run the risk of losing assets under management," warns Robert Keebler, an expert on individual retirement accounts and partner in the public accounting firm Virchow, Krause & Company LLP, in Green Bay, Wis. If you have to start by touting the benefits of the Roth genus, such as tax-free income when money stays in the account at least five years and no mandatory distributions come age 70, fine. You just want to be first in front of your clients so they know you're on top of this valuable opportunity, Keebler says. "Protect yourself. Money will move."
By now you are no doubt aware of the change enabling clients to convert a traditional IRA into a Roth regardless of income beginning January 1, 2010. Until then, the client's income must be under $100,000. Less publicity, however, has surrounded the absurd rule dictating how clients will report conversions to the Internal Revenue Service.
"If you convert in 2010, half of the conversion is reported as taxable income on your 2011 return and half on your 2012 return, unless you elect to have it all taxed in 2010," says Boston-based Jere Doyle, senior vice president at Mellon Financial Corp. Don't for one minute believe that easing the conversion tax pain is the raison d'etre for this bizarre reporting regimen. Rather, it was a way for the politicos to shift revenue to the optimal year for budgetary purposes, say analysts at CCH Inc., the Riverwoods, Ill., business information provider. But what does an advisor need to do now, besides alert clients to the opportunity?
A few things. First, understand the math behind converting. Clients will want to know whether it works to their advantage. "That depends on whether the tax-free growth in the Roth after conversion can compensate for not being able to invest the tax dollars paid to convert," explains Robert A. Vigoda, a partner in the private client group at Edwards Angell Palmer & Dodge LLP in Boston. "The longer that the funds stay in the Roth after converting, the more it makes sense."
Among the inputs to the excruciatingly complex analysis are the client's life expectancy and, for those who won't use the account during their lifetime, whether the beneficiaries are likely to stretch the IRA upon inheritance or deplete it. Other critical variables include the investment yield in the account post-conversion and the tax hit to convert, something that will take careful planning to minimize. While it may seem obvious to delay reporting 2010 conversions until 2011 and 2012, remember that 2011 marks the return of Clinton-era tax rates. Doyle suggests positioning clients to take losses that can offset the income the conversion creates.
In cases where conversion will make sense, develop a plan now for paying the tax toll, Vigoda advises. The money shouldn't come out of the IRA because that would make it a distribution subject to the 10% penalty tax if the client is under age 59.
A strategy for the client who earns too much to make annual Roth contributions (more than $160,000 married, $110,000 single) is to stuff as much money as possible into a nondeductible IRA before 2010, then convert it to a Roth. Tax will only be due on the earnings in the account, since the contributions were made with after-tax dollars. This year's maximum contribution is $4,000 (plus $1,000 catch-up for clients at least age 50), rising to $5,000 in 2008. Clients who make nondeductible IRA contributions must file IRS Form 8606.
TIPRA's heavy-handed revision of the kiddie tax rule may tarnish the luster of some of your past recommendations. Now a child under 18 with more than $1,700 of unearned income (interest, dividends, capital gains) is taxed at the parent's rate. It used to be under 14. The kicker: This change is retroactive to January 1. "We have clients who transferred property to children anticipating that they would be taxed at their own rates beginning at age 14, and now unfortunately they won't," says Michael E. Kitces, director of planning at Pinnacle Advisory Group in Columbia, Md.
How to tell a client this? "Remind him that he isn't worse off than if the assets had remained in his name. The income tax result would have been the same," Kitces says. "But often the primary goal was to move assets out of the parent's estate, so keep that in context. Tell clients that transferring assets to children still has benefits, just not as many as before."
The kiddie tax hike diminishes the appeal of UTMA/UGMA accounts for minors when compared with Coverdell Education Savings Accounts and Section 529 plans, both of which can provide tax-free growth for education, observes Alan Goldfarb, chief financial strategist at Weaver and Tidwell Financial Advisors in Dallas and Forth Worth. "But I am a little uncomfortable that Washington hasn't addressed the scheduled sunset of the 529 rules in 2011," he says.
Relief from the alternative minimum tax was one of TIPRA's primary goals and for many clients, the act's increase in the 2006 AMT exemption will mean the difference between being subject to the alternative rules this year or not. Be sure to run projections on software that incorporates the new exemption figures-$62,550 for joint filers and $42,500 for singles.
Yet another hallmark of the act is its extension of the 15% rate for capital gains and qualified dividends through the end of 2010. Investors in the lowest ordinary brackets pay zero tax on a portion of their gains in 2008 through 2010. "Now there is more reason to hold equities in personal accounts and fixed-income investments in retirement accounts," says Mellon's Doyle. He suggests revisiting clients' allocations across taxable and nontaxable accounts.
TIPRA also contains one noteworthy item to tell small-business clients about. Six-figure Section 179 expensing now continues through 2009, having previously been set to revert to a $25,000 maximum at the end of next year.