Unique Roth IRA Conversion Opportunity in 2010

On January 1, 2010, changes in the tax code occurred that will allow any taxpayer to convert a traditional IRA into a Roth IRA, regardless of his or her income. Each person’s tax situation is different but most current IRA owners (including profit sharing, 401(k) SEP-IRA’s) should consider converting to a Roth IRA.

IRAs and Roth IRAs are different in several significant ways. Contributions to a traditional IRA are deductible against income while contributions to a Roth IRA are made with after-tax income. This means while IRA contributions are deductible in the current tax year they are funded, when qualified withdrawals are made from an IRA account it is taxed as ordinary income. In contrast, qualified withdrawals from a Roth IRA (e.g., withdrawals after age 59½ and 5 years from the establishment of any Roth IRA or conversion of the Roth IRA account in question) are not subject to any income tax. Even withdrawals within the 5-year holding period for IRA Roths may not be subject to income tax due to the first-in, first-out rule. That is not the same with IRAs. There is a 10% withdrawal penalty applied to withdrawals made from an IRA before age 59½. Finally, traditional IRA owners must begin taking required minimum distributions at age 70½ while Roth IRA owners are never required to take distributions.

The major reason why some people open IRA’s and some people open Roth IRA has been income levels. Previously, a person’s ability to fund a Roth IRA was limited to individuals with modified adjusted gross incomes at or below $120,000 (or $176,000 for couples filing jointly). The ability to convert a traditional IRA to a Roth IRA was also similarly limited. An IRA to IRA Roth conversion offers higher-income taxpayers an opportunity to establish Roth IRAs for the first time.

The 800 pound gorilla standing in the room occurs when converting a traditional IRA account to an IRA Roth account: Uncle Sam wants his cut. Converting an IRA requires taking into account the income share of the account funded with pre-tax dollars. The government is giving everyone a break in 2010 by allowing taxes owed for a conversion to be split over the 2011 and 2012 tax years. For many taxpayers, this will mean treating as income the entire value of their accounts. IRAs that have been funded in part with after-tax dollars, the tax burden will depend on the share of accounts funded with pre-tax dollars (i.e. 401(k) funding that were converted to an IRA) versus after-tax dollars across all traditional IRA accounts. Thus, an IRA fully funded with after-tax dollars will nevertheless be subject to income tax upon conversion; if the taxpayer owns other IRA accounts funded with pre-tax dollars.

Given the substantial tax cost associated with converting an IRA to a Roth IRA, conversion will be based on your individual situation. For example, for a person with a relatively low value in their IRA accounts and which are expected to appreciate over time, it may make sense to take the tax hit now. Other reasons include: if you think income tax rates are going to increase in the future, or if a taxpayer expects to be in a higher tax bracket in retirement. Likewise, if you do not expect to use your IRA income in retirement then a conversion would make sense since IRA Roths have no forced distribution. Another benefit is that a taxpayer’s estate is reduced by the amount used to pay income taxes. Conversion may also make sense if you have current business losses and other deductions to offset the tax burden.

However, there maybe several reasons not to convert. If a taxpayer expects to be in a lower bracket in the future or needs to take distributions from their IRAs to pay the income tax on the conversion, the answer is murky. Also, if the IRA account is destined for charity, withdrawals from the account will never be subject to income tax after the taxpayer’s death, diminishing the benefit of conversion.

Another issue to concern people that convert to a Roth IRA is a possible market decline that would lead to overpayment of income tax. If this does occur, a taxpayer may re-characterize and effectively undo a conversion until October 15th of the year following the conversion. Of course, there is no guaranty the market decline will occur before the re-characterization deadline. Converting taxpayers should also consider segregating converted accounts by asset type, which will facilitate re-characterizing only those classes of assets that have failed.

For anyone that is considering a conversion, reviewing the potential future savings that occurs from a conversion and comparing them against the cost of converting is critical. My best advice is to talk to your financial planner, accountant or other trusted financial advisor to determine whether a conversion makes sense in your situation and to what extent to convert, as conversions can be done in part and over time.

Basics of Estate Planning: Probate, Intestacy and Wills - How does it Work

Last month, I provided a basic understanding of how one person, or a group of people, owns property. I received a great deal of feed back on those basics and I thought I would go into detail about another introductory aspect of estate planning – how your will, intestacy and probate work together.

A will is a legal document in which a person, the testator, specifies the method to be applied in the management and distribution of estate property after death. A will can do more then simply distribute property to heirs. It can also establish testamentary trusts, name guardians for minor children, name an executor or provide funeral instructions (though I would not recommend that in a will). In other words, the testator is providing post-death instructions to be followed regarding his or her property through the will.

Clients often mistakenly think that a will governs all of a person’s property. As I described in the January edition of “The Future Estate,” that is not the case. Property that is owned in joint tenancy or controlled in a transfer-on-death account will not be governed by a will.

A person who dies without a will is said to have died intestate. State intestacy statues could also be controlling if the will is denied in probate or found invalid for some reason. Also, intestacy statues would be active if a testator’s will does not distribute all of the property owned by the testator. For example, if a person owns a piece of real estate not listed in a will, not owned in joint tenancy or controlled by some other legal mechanism, then intestacy statutes would kick in.

Since the government does not like chaos, they have enacted various statutes establishing who receives what share of the estate property. Each state has different rules that govern intestacy distribution. Generally, the intestacy statutes are influenced by the family structure. For example, if a person was in a second marriage and had children from a previous relationship, those children outside of the marriage would typically inherit a portion of the estate regardless of need for the surviving spouse. (See this Month’s Estate of the Month as an example).

Probate is the legal process in which a court determines how an estate will be divided and covers estates either with a will or in intestacy. If you have a will, the court will follow your Last Will and Testament in distributing your property, unless it is contested by your heirs. If you have died intestate, the probate court will appoint an administrator and follow the intestacy statues and distribute the property accordingly.

There are a couple of misconceptions about probate. Some people think having a will avoids probate. This is not true. A will is used in probate to determine who receives what property, who is appointed guardian to any minor children and who will be responsible for carrying out the wishes contained in the will. In other words, a will takes precedent over a state’s intestacy statutes.

The biggest issues with probate, particularly if you do not plan correctly, i.e. you die with out a will, are expense, intrusion of your private matters and time. If you do not have a will, the court will need to appoint an administrator. This can take a long time and cost a significant sum of money. The court will often charge a hefty fee, usually based on a percentage of the value of the estate, to go through probate. To avoid probate, other estate-planning devices should be used. Joint tenancies, pay-on-death accounts and living trusts are some of the most common estate planning methods. Each has their benefits and detractions and I detail those methods in future Newsletters.

Estate of the Month: Steve McNair

As most people know, I am a huge football fan. My love of football sometimes crosses paths with my professional experience and, unfortunately, provides a talking point on estate planning.

Last month, I detailed the tragic estate issues impacting Sean Taylor’s loved ones after his death. This month the estate of another professional football player - Steve McNair –will provide another lesson on how to prepare for the worst. I will not go into the details or pass judgment on Steve McNair; I will only say that he was shot and killed on July 4, 2009. As with the Taylor estate, the tragedy only grows from there.

According to reports, McNair made over $90 million during his 13-year career playing for the Tennessee Titans and the Baltimore Ravens. McNair was survived by his wife and two minor sons from that marriage. McNair was also the alleged father of two other minor children from before he was married. A thorough search of McNair’s properties was conducted and it was determined no will existed. At the time of his death McNair was reported to have a net worth around $20 million with most of the property listed in his name only. Simple math makes me wonder where $70 million went, but, as I said, I won’t judge.

On July 15, 2009, McNair’s wife, Mechelle McNair, filed Emergency Petition for Letters of Administration to the court, naming only her two sons heirs to the estate and seeking to be appointed the personal representative. The court appointed Mechelle McNair personal representative to McNair’s estate and required her to file with the court in 60 days an inventory listing all of McNair’s property with an estimate of its fair market value. Mechelle McNair stated the two children born out of wedlock should file claims for their inheritance with the estate.

The inventory of McNair’s estate was recently filed listing estate assets at around $19.6 million. Most of this money (about $16.9 million) was invested in stocks and bonds. McNair also owned at least two corporations, one of which was a cattle business called McNair Farms, Inc., located in Mississippi. This was not all of the property owned by McNair because any jointly owned property would have passed outside of probate and would not have needed to be listed.

Tennessee law allows for a widow’s election, meaning that Mechelle McNair can elect to receive a different amount from the estate then what she’s otherwise entitled to get. In Tennessee, this means 40% of the assets, rather than the one-third share she’d get under the intestate law. She recently filed to receive the 40% election.

Here is my quick analysis, likely outcome and suggestions from this tragedy.

As Steve McNair’s spouse, Mechelle McNair, probably lost the most from the lack of a will. The 40% elective share that Mechelle McNair took is reduced by the value of any assets she received through joint tenancy, or otherwise, outside of the estate. Because she chose the 40% option, it suggests Mechelle didn’t receive as much outside the estate via joint tenancy of property like the McNair’s home or joint bank accounts. A simple sweetheart will, leaving everything to Mechelle, would have given her the entire estate.

McNair’s four minor children are also financially impacted by the lack of a will. Assuming that the paternity of the two minor children born out of wedlock is proven; they will each receive a one-fourth share of what is left after Mechelle McNair takes her portion. Since all the children are minors, each mother of the minors will have to petition the court to be appointed legal guardian of the minors’ inheritance, since it will be put in a trust account. Their guardianship lasts until each child turns eighteen. On their eighteenth birthday, each McNair child will receive their entire inheritance free and clear of any strings. The proverbial spendthrift child buying a Porsche comes to my mind. Some type of trust, either revocable living trust or testamentary trust, would allow McNair or his trustee’s some control over his minor children’s inheritance.

If there are losers, then there must also be winners. In this case, the professional advisors utilized in creating a post-estate plan - lawyers, accountants and financial professionals will likely be the first winner. Spending a little money up front in creating an estate plan with an attorney in conjunction with other financial professionals would have saved thousands of dollars in the long term. Lawyers will petition the court for establishing the trust accounts and dealing with non-normal distributions of the trust account or for changes to the account, since the courts will likely take an active roll in any inheritance. If McNair had established a trust for his children, then he could have named a trustee whose judgment he valued, to watch over the inheritance instead of the court. Second, he could have established conditions under which inheritance would be turned over to his children’s control to mitigate wanton spending habits such as establishing appropriate age levels.

Further, since McNair had a business located in another state, ancillary probate will have to be opened in Mississippi to determine the ownership of the cattle business which will also drive up the probate costs for the estate. Creating an estate plan with ownership of the cattle business in trust or other business succession plan would have likely negated ancillary probate.

The other big winner in McNair’s estate is the state of Tennessee and Federal government’s tax coffers. By not drafting an estate plan that would take tax liability into account, McNair’s estate lost numerous tax sheltering arrangements. A few steps would lower the Federal and State estate tax bill. Instead, McNair’s estate will owe millions in taxes. In 2009, the Federal Estate Tax exemption on estates was $3.5 million. Any estate over that amount will be assessed at a rate of fifty-five percent. This ignores whatever the estate tax rate is in Tennessee and qualifying exemption. Taking a very simplistic view, ignoring the state estate tax liability, election, etc and their impact on Federal estate taxes, McNair’s estate would owe $8.855 million dollars to the U.S. Government.

Taking a few steps, like moving property into a trust, transferring assets into a joint tenant account with his wife or taking other taxes advantageous transactions, would have saved McNair millions. While it is hard to begrudge someone that still has millions of dollars left after paying the tax man, I doubt McNair would have wanted the millions of dollars he earned playing football to simply disappear rather than go to support his family.