As I’ve discussed in previous newsletters, there have been a number of changes to tax laws in 2010, and there are none that are likely to have a wider impact than changes to Roth conversion rules. The changes have made conversion more attractive – or even possible – for many, but whether or not you can or should consider a conversion is complex. For that reason, I’ve promised a newsletter article to help you determine if conversion would make sense for you and that article is below.

Given the length of the article, I had intended to make this a one article newsletter, but the markets just wouldn’t cooperate. Because of the ups and the downs of the last few weeks, I thought it might be helpful to share our views on the markets, and provide some information on how portfolios have held up and what next steps might be. I’ll go into a good bit more detail in the second quarter commentary for clients, but hopefully this brief note below will help put things into context for you.

If you have any questions or thoughts regarding the newsletter, please let us know.

Best regards,

Micah Porter, CFA, CFP®

Understanding Roth Conversions
Micah Porter, CFA, CFP®

One of the landmark pieces of legislation over the last 40 years was ERISA, the Employee Retirement Income Security Act. Most corporate-sponsored retirement plans are governed by ERISA, for those not participating in a company-sponsored retirement plan, the legislation also established Individual Retirement Accounts, better known as IRAs. A bit more than two decades later, the Roth IRA, named after the late Senator William Roth was established, and ever since, many investors have been scratching their heads and consulting their advisors over which type of plan would be better for them.

A few of the primary traits that traditional and Roth IRAs share are as follows:

Not everyone can contribute – the rules about who can contribute to both types of IRAs and the amounts they can contribute are complex. For both types of accounts, earned income is necessary in most cases, but from there the rules diverge. It’s because of this complexity that during tax season we encourage clients we think might be eligible and able to contribute to check with their accountants to confirm both eligibility and allowable contribution amount.

What’s in the account isn’t taxed – neither gains nor income that occur within either traditional or Roth IRAs are taxed.

The accounts can have assigned beneficiaries – primary and secondary beneficiaries can be assigned to traditional and Roth IRAs, and those accounts will pass directly to the beneficiaries.

Three of the main differences between the accounts are as follows:

Tax on contributions and withdrawals – this is the primary difference between traditional and Roth IRAs. Contributions to traditional IRAs are tax deductible – that is to say they are made with pre-tax dollars – while contributions to Roth IRAs are not tax deductible. However, the situation is reversed when it comes to withdrawals – there is no tax on withdrawals from Roths, the entire amount of the withdrawal from a traditional IRA is treated as income.

Requirement to take withdrawals – for traditional IRAs, the IRS requires that account owners begin taking distributions in the year they reach the age of 70.5. This required minimum distribution, or RMD, is the government’s way of increasing the likelihood that the income used for IRA contributions is taxed at some point in your life – I like to think of this as the “Render unto Caesar rule”. There is no such rule for owners of Roth IRAs – they are never required to take a distribution, as the income used to contribute to this account has already been taxed. Rules for beneficiaries for both types of accounts differ.

Rules on distributions prior to age 59 1/2 – because Roths are funded with after tax dollars, rules regarding taxation and penalties on distributions before age 59 1/2 are a bit more relaxed than those for traditional IRAs. Thus, in some instances, some funds within a Roth can serve as an effective emergency fund.

Based on the above, there are two takeaways for those that can contribute to either a traditional IRA or Roth. First, if one expects to be in a lower tax bracket in retirement, then the traditional IRA may make more sense. The reason is that the tax savings on contributions now to a traditional IRA may outweigh the tax that will need to be paid when withdrawals are taken. The converse – a lower tax bracket while working and a higher tax bracket when retiring – likely makes a ROTH more attractive.

One other factor to consider when choosing between a ROTH and traditional IRA is your planned use of the assets. The lack of any required minimum distribution for the account owner coupled with the lack of tax on any withdrawals makes the Roth an attractive estate planning vehicle. Non-spousal heirs will have to take required minimum distributions, but they can stretch those distributions over years, all-the-while allowing the accounts to grow tax free.

Regulations also allow for a transfer of assets from a traditional IRA to a Roth IRA, which is popularly known as a Roth conversion. A conversion is a taxable event, as the amount converted is treated as income, and prior to 2010, that tax had to be paid in the year of the conversion. However, a change in the rules for this year allows for the tax to be spread over the two years following the conversion – 2011 and 2012 in this case. Additionally, income limitations in previous years reduced the number of people that could convert, but those limitations have been removed for the 2010 tax year.

So should you consider a ROTH conversion? The following are some factors you should consider:

Is your tax bracket likely to be a good bit higher in retirement? If the answer is yes, then the conversion may make sense.

How much tax can you pay out of non-conversion assets? You can use part of the conversion assets to pay the taxes on the conversion, but that tends to make the conversion less attractive over the long-term, and the money used to pay taxes may be subject to a penalty. The bottom line is the greater the amount of taxes you can pay out of pocket, the more attractive conversion will be. One other note on taxes – for 2010 only, investors can elect to defer taxes and pay them over tax years 2011 and 2012.

How long until you need the assets? Longer time frames tend to favor Roths over traditional IRAs. The reason for this is a combination of growth over the long-term and the fact that withdrawals from traditional IRAs are taxed while Roth withdrawals are not taxed.

To understand this, assume an investor is able to contribute $4,000 to a Roth or $5,000 to an IRA (by taking the additional tax savings on the IRA contribution and adding that to the contribution itself). If that amount were to grow at 8% over 20 years, the Roth would have a balance of $18,643 while the traditional IRA would have a balance of $23,304. However, depending on the investor’s tax bracket, the higher IRA balance might be more than offset by the taxes on any withdrawal, and the longer the account has to grow, the greater the impact of the taxes.

What is the impact to your tax bracket – because IRA withdrawals are treated as income, completing a conversion can push you into a higher tax bracket and potentially lead to phase outs of deductions or other negative impacts. Make sure you understand this impact before completing a conversion.

Do you plan to pass financial assets on to your heirs – if you do, a Roth can be an effective tool for doing so.

The decision regarding whether or not to complete a Roth conversion is a complex one, but given rule changes for 2010, more investors are eligible to make a conversion than ever before. Taking a look at issues like this is part of comprehensive planning, so if you’re a client who has questions about whether or not a conversion might make sense for you, just let us know.

A Few Thoughts on the Markets
Micah Porter, CFA, CFP®

Volatility has returned to the markets over the past few weeks, which is something that we don’t find particularly surprising. Valuations had gotten ahead of themselves as exuberance took over and investors hoped for a V-shaped recovery. However, we’ve maintained that such a robust recovery was unlikely, and recent data has backed that up. As a result, investors have become increasingly skittish and events that would normally be overlooked in more confident markets have driven wide market swings.

Portfolios have held up relatively well with the S&P down roughly 12.6% through Friday from its April peak, while the decrease across all Minerva portfolios has been 4.7%. Defensive positioning has been key in lessening the impact of the equity markets, and we’ll continue to maintain that positioning until either a sharp drop in the equities markets provides bargains or economic data indicates a stronger recovery than now looks likely.

Where the markets go from here is anyone’s guess, although increasing investor pessimism coupled with markets that still appear to be a bit overpriced make continued declines a distinct possibility. Should that happen, defensive positioning should continue to help portfolios hold their values relative to the overall market and provide the capital needed if further sharp drops lead to likely bargains. I’ll outline what I mean by defensive positioning and provide targets which, if hit, would lead us to lower the defensive level of portfolios in the 2nd quarter commentary. In the meantime, if you’ve got any questions or if you’d just like to chat, feel free to give us a call.