John G

John O, I totally agree with your very good summary: "... GENERALLY the Roth conversion will beat no conversion, provided (a) there is a desire to stretch out deferral to the max (B) there is an Estate Tax liability © the income tax rate is not GREATLY lower after retirement than at present (d) conversion tax is paid from outside assets." Anyone with significant assets or a complicated situation clearly needs professional help to run the numbers. If a couple of million are involved, it might make sense to have two different professional teams working on the problem.

One of the reasons for this string of responses was the following first comment from Art E: "What excapes me is why convering $2M to a Roth is good for either the owner of the IRA or his/her heirs. The $2M conversion will make the taxes due at conversion the highest level. My progran shows convering $2M of a $5M IRA will cost the heirs from $1M to $2M after tax." The statement seems fairly simple, but assertion is totally wrong. The conclusion has never been backed up by any comprehendable math. A large asset household that is still eligible for a Roth conversion may find Roth conversion attractive. Reason: a large part of the conversion taxes are offset by reduced estate taxes. Those rules may change in the future, either favorably or unfavorably to this scenario, but that is how the math works right now. Lets not get confused or distracted about the most fundamental point. Art E also recently said: "That other option..... It's for the case where R&J would withdraw a fixed percentage of their IRA assets annually from age 61 - 70, then drawdown the remaining IRA over only 15 or so years (even to the extent of taking withdrawals much greater than needed or required toward the end of the 15 years) and investing the after-tax excess each year in stocks in their taxable account. The results show this approach is much better for the heirs than the 2M Roth conversion, by about 1M if R&J die at age 85. The Roth is not quite as bad if the if they go earlier; but it gets worse if they live longer" The difficulty with the above scenario is that payouts to the parents must be valued in the same terms as some snapshot of net residual estate. Classic economic studies would typically convert all of these amount to "present value". That is how the economic value of bridges and airports are calculated. But Roth models tend to focus on income streams and assets at the end of some study period. You can not compare two different scenarios if the payouts and residual asset value are not evaluated consistently. I don't believe Art E's conclusion makes sense and suspect the problem is in how the program evaluates amounts in different classes over time. A Roth conversion for a high income family essentially allows you to buy a Roth at "half price", that is for half the conversion taxes. For this to be a bad idea, the family must have a way in the future of taking very large payouts at half their normal tax rate. Not very likely. Other conclusions are probably due to math errors or the problem not being set up consistently. We should end this stream of comments. Art is telling us about some model that seems to support (I conclude) his bias against Roths. He is not the creator of the model. He did not set up the example, nor is he the client for whom the model was constucted. He was not trained in the use or mis-use of this model. He does not apparently have access to the code or equations. At this point, a working version of this model is not available to others. The financial planners and CPAs have voiced plenty of skepticism.... but this is like trying to disprove an some vague "urban legend" that happened to someone in some nearby town. It is like reasoning with the flat earth society, which persisted for many decades apparently just to tweek the establishment not to enlighten. I have a good mallet, does anyone have a wooden stake? [This message has been edited by John G (edited 12-21-1999).]

I guess your question hit the a blind spot with the folks who comment on this site. I don't know the direct answer to your question but I think I can recommend a work around. Instead of having a payroll withdrawal, you may be able to arrange a automatic "check" to draw upon your checking account. This could be done once a month for a slightly larger amount. Many mutual fund companies can facilitate this. If that does not work, try the more conventional route of writing a periodic check. In a few years, your circumstances may enable you to meet the mutual fund requirements. Good luck. [This message has been edited by John G (edited 12-18-1999).]

BPicker, You comments caught me by surprise. My information dates back to around 1994 or so, my only documentation from that period are four xerox pages referenced at the bottom as copyright Tax Management Inc, a subsidiary of the Bureau of Nation Affairs Inc. I will condense the material as follows: Detailed Anaysis II Status of Taxpayer as Dealer, Trader, or Investor The tax consequences of the transactions discussed in this portfolio may differ significantly depending on whether they are carried out by (1) a dealer, (2) a trader, or (3) an investor...... The regulations thus clearly recognize that a person may be engaged in the trade or business of buying and selling securities without attaining dealer status..... (cites Supreme Court rulings)... [the taxpayer] "to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer's primary purpose in engaging in the activity must be for income or profit"..... While the trader status does not transform gains and losses from sales and exhanges of securities into ordinary income and loss, the trader's expenses relating to his trade or business are full deductible "above the line" items. Thus, unlike an investor, a trader's expense, including subscriptions..[long list] are deducted in determining adjusted gross income rather than as itemized expenses. end of extract The general direction of this material is that you are investor if you hold long term (Yeager Est. v. Comr. TC memo 1988-264, aff'd, 1989-2 USTC 9633 2nd Cir 11/19/89 was cited). You are a trader if this is your primary activity, hold short term, make lots of trades and do it for profit. (print to small and blurry to see citations here) That describes me in the early 1990s. I thought that since Michael did not have a conventional job that he also might qualify. My CPA ran it up a few flagpoles before he agreed with the Sched C trader option. I not aware of any election requirement. My layperson view is that trading can be a business like any other, the main problem would appear to be distinguishing it from more conventional investing. With the late 1990s internet trading, I would not be surprised that the IRS has tried to further define the occupation. Any of you CPAs have daytrader clients? I would like to hear more on this topic. [This message has been edited by John G (edited 12-17-1999).]

Yes you can. You will need to meet the income requirements to qualify each year. Of course, tax law changes may enhance or hurt your plans.

Andrew, the prior answer was correct, all gains/losses both long and short will be reported on Sched D and the first page of your 1040. If you are close to the income threshold for a Roth, you may still get to qualify. First, take any tading losses you may have to offset gains. Second, you have the option to file a Sched C business activity as a "trader". Regular long term investors do not have this option, but what you have described may qualify as a business activity of "trading". You still report your gains/losses, but you can write off business related expenses such as computer, software, fax, answer machine, cell phone, copier, office furniture.... perhaps even a car. You can use the Sec 179 expense option to immediately write off up to $19,000 in 1999. Talk to your accountant before you act on this. [This message has been edited by John G (edited 12-17-1999).]

Rules? You expect Congress to write rules that make sense? You must be young! First, make sure you have the right income threshold for your circumstances. The threshold changes for conversions vs contributory Roths and for married/single. Why? Beats me. I am not sure why there should be any income limit since these restrictions probably only impact about 2% of the population. Gee, are they afraid Bill Gates will open a Roth? Second, if you still don't qualify for a contributory Roth IRA this year you may qualify for a regular IRA. If so, you can reclassify the 1999 Roth to regular, then if your income is under 100K next year, convert it back to a Roth. Lots of paperwork to get you from point A to .... point A again. Maybe you should email your Congressman and Senators and tell them you prefer simple rules with fewer restrictions. You get the biggest laughs from a CPA when you talk about tax simplification.

Art, I gave you a very basic example to demonstrate how a substantial Roth conversion could be extremely benefitial in estate planning and provide heirs significantly greater after tax assets. I stand by that analysis, Roth wins over not converting the IRA (BAU case). You previously made some sweeping conclusions that Roth conversions were bad... my basic case shows how you were wrong by $2M in net after tax dollars for the heirs. In your "Assume" paragraph in the very first sentence you pose the situation where the IRA owners can live on non-IRA assets and makes no withdrawals..... well that is exactly the case I presented you. Roth wins. The rest of that paragraph is a total hash. You are definitely mixing terms and perspectives and have not set up a consistent scenario. You talk about an 18% cap gain tax rate on stocks.... what is that? There are no cap gains on any transactions in either regular or Roth IRAs. You talk about a scenario with no living expenses, then you talk about funds used for living expenses. You can't just wing it when you are setting up a scenario, the assumptions must be clear AND consistent. A stream of withdrawals would not make the Roth conversion scenario worse, but it would reduce the benefits. I can not think of any reasonable scenario for a high asset family where the Roth would be a worse case. If you could construct the problem correctly, you will find that the Roth case would be attractive. You need to stop posing as an expert at this site. Your understanding of IRAs and Roths is limited. You seem incapable of setting up a clean scenario with consistent math. A combination of four CPAs/financial planners have told you that your conclusions are wrong. Maybe you should read/listen and stop trying to enlighten. [This message has been edited by John G (edited 12-17-1999).]

"....I don't understand the significance about half the conversion taxes being offset by tax savings. The numbers showed that the taxes were about 50% ,so you are correct and half of the conversion taxes are "recovered". But what about the other half ? Half a M isn't peanuts. And then what about the loss in growth of the full tax amount over 25 or so years. If the tax was about 1M on the conversion, wouldn't that amount have grown to over 4M in 25 years, or about 2M net after a 50% tax. This looks like a net loss of about 1.5M to me. However, I do realize that where the 1.5M is, i.e. in an IRA, or in a taxable account in stocks, or etc., is also very important. " REPLY: With all tax rates pegged at the max because of the magnitude of the assets, it is the inheritance tax offset that makes the Roth so attractive. You don't see this because you confuse pretax dollars with after tax amounts. Lets get an apples to apples comparison.... the after tax value to the heirs in 25 years. I will make the following assumptions 40% income tax rate, 50% inheritance tax rate, annual investment return of 10%, 1M conversion tax cost, 2.5M conversion (thus 2.5 * 40% = 1M), parents die at 24.9 yrs. First the BAU case. The 1M you did not pay in conversion taxes could over 25 years at 10% grow to $10.8M. (Try using that HP12C, your 4M would assume a 5.7% growth rate) Then add the unconverted IRA which would grow from 2.5M to 27.1M using 10% over 25 years. Total pretax assets would be 37.9M. Estate taxes cut this in half, then income taxes reduce that by 40% which gives the heirs an aftertax net of 11.4M. What was the value of the Roth? The 2.5M Roth growing at 10% for 25 years creates 27M. But estate taxes will cut that in half, so the heirs would have 13.5M in after tax dollars. Lets see, 13.5M the Roth way, 11.4M with no conversion. Apples to apples. Two million more apples (dollars) for the Roth conversion scenario. All with a HP12C. More importantly, a simple model with consistent assumptions. The Roth scenario looks better when you consider that that the heirs will likely have the tax shelter for many years past the 25 yr snapshot. The Roth becomes more attractive with a higher investment return. An additional benefit is that the parents do not required distributions. [This message has been edited by John G (edited 12-16-1999).]

Mike: in a court the legal response to your question would be that you "have no standing", case dismissed. You are not apparently the heirs. You do not appear to be IRA owners. Therefore I wonder why you want to get involved. From my perspective, its none of the (presumed) heirs business either, the parents can choose any path they want. Its their money. But to answer your question directly, the hourly range for expert assistance varies widely, perhaps $100 to $250/hr and up. You can get general opinions with no analysis by investing about two hours with a CPA/lawyer. Setting up a model with specific data and running some scenarios will take at the minimum 4 hours, it might take a lot more if the facts are complicated or you want to examine multiple cases. You said "they were told it would be best"... sounds like they consulted with professionals. My guess is that they decided to shrink their taxable estate by doing the Roth conversion. This is a pretty well known estate tax management option. They may have also taken this route to avoid taking any distributions from the traditional IRA.

I am not convinced that Art E is an expert in Roth conversion issues or inheritance taxes. His role in the above scenario is obscure... was he just a third party "the details of the analysis I saw", or was he the financial planner, or the model builder? His credentials are not disclosed. Is he a mathematician, a tax accountant, lawyer or just some retired guy with a new hobby. The scenario that he describes apparently involves other people. The facts are very loosely reported, I would call them vague. The "analysis" seems to be a classic mix of apples and oranges. Funds dispersed for living expenses, MRDs, post inheritance net assets, income vs inheritance taxes.... This scenario is so full of details and multiple objectives (or points of view) that it would take weeks to construct it correctly. It is not enough to be mathematically sound (which is by no means a given) but also be based upon logically consistent assumptions. I don't buy the conclusion reported by Art E. The magnitude of the assets would indicate that max income and estate tax rates would be likely. The conversion taxes would be about 1/2 offset by the reduction in inheritance taxes. You can make the problem a lot more complicated but that relationship doesn't change. Art E thinks you can't do analysis with a HP12C. Gee, someone should tell HP. The problem with overly complicated mathematical models is the are prone to have errors in their structure, assumptions or unit specifications. When the scenario gets so complicated, especially if you are compounding over multiple decades, the very small errors may grow in significance but remain hidden in the output. That is the beauty of very small (back of the envelope) models. My mom used to call that common sense. Art E doesn't get it. His complicated scenario just doesn't make sense. I don't believe in hyping Roths as the answer to everyones problems. People can make up their own minds and assess how the future might play out. This site tries to provide expert insight into the rules and possible applications. Art E falls short of that objective. In my previous comment I asked some questions about the model source and the knowledge/training of the users. No answers. You might add the the list, who vetted the model? Why trust the poorly documented work from an unknown source that defies common sense?

BPicker - thanks for jumping in on what appears to be very bad analysis. I agree with you. You can truely do this analysis on the back of an envelope with an HP12c and get a more reasonable result. The estate taxes will be around 50%, the income tax rate will be near that depending upon where the person lives. If I was fooling around with 2M, 5M or 7M I would be running a blind parallel analysis with atleast two CPAs to run the numbers and ask them to explain any differences. Any lower level of effort would be foolish. Adding to your aside: Lots of folks run models an plug different growth rates for taxable vs IRA, pre-retirement vs post which can produce weird results. And you get some folks getting confused over real vs nominal dollars and the various ways to represent inflation.

Various comments on the Art E "model" results: The above scenario sounds like an "urban legend", a very vague scenario. What model was used? Where the folks crunching the numbers knowledgeable about Roths/tax laws, were they even trained to use the model? I have a hard time believing that the Roth conversion would be so horrible given that about half of the conversion taxes would be offset by estate tax savings. I draw upon about 25 years of experience in evaluating other folks analysis, spreadsheets and models. More than half that I have examined have a significant error. And a surprising number of times there are multiple errors! Wrong units (like a certain $135MM Martian probe that crashed), inconsistent assumptions, poorly labeled output, sensitive imbedded assumptions.... there are lots of things that can go wrong. Errors are surprisingly common when the output extends beyond the common economic framework. The user often can't see that the result is wrong, and that very professional looking printout is soooo seductive. Too often the user views the model as a substitute for thinking, rather than a tool to help organize thinking. Let's be honest, most models and forecasts turn out to be wrong, even after just a few years. Besides mistakes.... we have unexpected events, changes in rules, etc. A scenario involving two different tax payers, two decades of time and both inheritance and income taxes will generate many permutations. It just doesn't make sense to talk of a "result" as is it is a single number. The above cautionary notes not withstanding, I am a great believer in models. I am just a lot more skeptical about the validity of "unussual" results. [This message has been edited by John G (edited 12-13-1999).]

To add the BPicker response: because none of the transactions have an impact on your tax return in the year you trade, your recordkeeping is simplified. You keep track to know how well you are doing, not for IRS reporting. Wouldn't that be nice for taxable accounts!

Follow up on inheritance changes: Over the past few years there have been multiple proposals to change inheritance taxes. Ones that come to mind include: (1) dropping all inheritance taxes, (2) jacking up the threshold to $5M , and (3) setting the threshold to $10M. Not saying any of these become law, but the momentum seems to relax the rules since more people are finding they trigger the taxes as retirement funds and housing assets climb in value. My view is that while a good part of this is election year trial balloons, eventually they will relax estate taxes which many families think are grossly unfair. Historically, not many voters were effected... that seems to be changing. When you pay Roth taxes, you reduce your taxable estate.... for the moment. [This message has been edited by John G (edited 12-08-1999).]

I am not sure your idea buys you much. You can't use the recharacterization to after the fact put the best performers in the Roth and send the rest back. You are moving value not shares. I suspect this client is jumping through a lot of hoops to keep 2000 income under the threshold.... such as keeping the money to pay the taxes in munies for a year? You often end up paying a big price for distorting normal behavior. Converting to a Roth may reduce this persons taxable estate (although the rules may be changing) and give the client more control over IRA withdrawals. I would argue for simplicity: convert the part with which you are comfortable. Put your energies into making investment/business decisions not trying to game the system.

Would a potential solution to this problem be a Roth conversion? Depending upon income levels, this person might have a very attractive window after leaving the work force and before various pension/SSN kicks in to convert IRA assets to Roths.... perhaps a phased conversion. That does not solve the early age issue, but might have some other benefits. A second option might lie in home equity. The new rules allow a couple to sell their house and keep the $$ if they are down sizing, which is not an uncommon option for empty nesters. The limit I believe is a 500K gain. Another option is to structure a reverse mortgage, so that you are receiving an income stream from the bank.... then you could revert back to a standard mortgage after the five year period. This might be viable if the couple has any penalties on withdrawals, or wants to keep the assets invested. [This message has been edited by John G (edited 12-06-1999).]

There is no age limit for Roth or regular IRA for a child.... atleast not from IRS regulations. However, you will have to check with a few custodians as some are not accepting accounts for children. Don't know why some decline the business, just keep asking and you will find someone (Schwab says yes, we should probably have a list on this site!) The real issue is "earned income". I believe you can hire a child... but you have to do everything you would if you hired an adult. Pay ALL the applicable taxes. Keep records. Keep some documentation on what the child does for the pay.... and it better pass a basic reality check. Remember, dividends and interest do not count. There are lots of ways kids get earned income: modeling, local newspaper delivery, babysitting, etc. The Roth is a great shelter. Starting early in life makes it an even better idea. Good luck.

To Gyee: see BPicker answer above your question. Sounds like you are getting the beaurocratic garbldy gook from your custodian. My guess is that the counter staff are not up on the current rules. Go up atleast one level to a supervisor, or ask for their retirement account specialists. If your custodian insists on multiple accounts, let your feet do the walking... find another institution. I recommend the direct transfer approach, you do not want to have them give you a check. This issue was addressed many months ago and any reputable firm should have adjusted their procedures. You just don't need two Roth accounts anymore. Plain and simple.

I can't directly answer your question, but I have some ideas. You can start a business and write off the initial start up costs. The losses pass straight though to the front page of your 1040. You might be able to arrange a leave of absence for one week with your employer. You may see if you last paycheck will actually be dated in Dec....my wife is a teacher and the district always posts the last paycheck in early January. Anyway you look at it, you are cutting it very close. Things that could push you over the top again are Sub-s corp K1s (which show up a few months into the next year) , December posting of capital gains in mutual funds, misc interest payments, etc. Others will have to comment on the deferal of income issue. Did you consider telling your employer that they made a mistake and you really didn't deserve that bonus? Just kidding.

From the Rothira.com site: Not everyone is eligible to make a contribution to a Roth IRA..... maximum income cap for taxpayers to be eligible to make a Roth IRA contribution. For single taxpayers, the ability to fund the Roth IRA starts to PHASE OUT (my emphasis) at $95K of MAGI and disappears completely at $110K. Taxpayers who have existing traditional IRA accounts may be eligible to convert their accounts into Roth IRA accounts. The requirements are that the modified adjustment gross income not exceed $100K.... For taxpayers who desire to convert to a Roth, and whose income is close to the threshold, certain steps can be taken to reduce their MAGI. Among the steps are to move money in interest bearing accounts into either tax free bonds, or Treasury bills that will be taxed in 1999 (Treasury bill interest is taxed at the bill’s maturity, even though it is paid up front). Don’t worry about paying a penalty if you break a Certificate of Deposit, as the penalty will reduce MAGI. Taking capital losses will also help, particularly if you have capital gains. [but the max Sched D net tax loss is $3,000 in one year] Also useful is putting money into 401(k)’s, 403(B)’s, Keoghs, SEPs and SIMPLEs, to the extent that you are eligible. But putting money into an IRA will not help..... end of extract And I will add one more idea, you can start a business and write off investments in the firm via sec 179 expense and that reduces your AGI. [unlike capital gains, the $3K limit does not apply to valid business tax losses] So you have atleast two options to wiggle under the thresholds. Making a regular contribution, then converting it to a Roth seems to meet the rules. I guess that makes sense if you fall into the near 100K income area. I have never seen it proposed before, but it looks like there are loopholes caused by the arbitrary income thresholds. I hope others will add to these comments. [ above comments clarified per next comment, my apologies for sloppy text ] [This message has been edited by John G (edited 11-18-1999).]

Please specify marital status and rough AGI number. The requirements for new Roth are not the same as existing IRA conversion. Note, there have been proposals to change the income thresholds (recently vetoed), so the rules may change again.

For other first time IRA folks: you also can build up an IRA by making automatic monthly contributions. Virtually all mutual funds allow this option. In other words, you don't have to wait until you have $2,000 to get start. And, there is nothing magic about $2,000 either... you can open an IRA with $1,324 or any other amount as long as you meet the minimum set by your custodian (which vary substantially from custodian to custodian and may be lower for certain options such as the monthly deposit). There are some mutual funds that will let you get started with as little as $250 or $500.

As John said, YES. The reason you send two checks is to make sure the custodian correctly designates two different years. So mark the year on each check, then confirm that they did it correctly when your next statement comes. In the tax rush season, this sometimes gets screwed up. Welcome to the world of investing. The toughest step is sometimes just getting started. A January deposit gives you tax sheltered growth for a longer period and is a smart way to go. Good luck.

Advisability: further thoughts If there are many heirs, taking spread out distributions, with very low tax rates... then you might be able to craft a case the heirs might prefer a standard IRA. Remember to factor in the different state income tax treatment. The deceased and the heirs may live in states with different income tax rates. If everyone lives in the same state, then at first blush this would probably not be an issue... but what if the heirs plan to move to a no tax state such as Florida? You were absolutely right this is an "interesting situation".