When it comes to advising clients on Roth IRA withdrawals, there is more to this process than simply spelling the various rules they’ll need to follow to avoid paying costly penalties. Indeed, it is the responsibility of the enrolled agent, as the registered tax return provider, to provide taxpayers with actual strategies for minimizing taxes when other action is taken on Roth IRAs. One such transaction where the RTRP can typically add value is the Roth conversion. These conversions are so popular, in fact, that they are often a focal discussion topic in EA CPE courses.
Because the number of Roth IRA conversions per year is unlimited, and taxpayers have the ability to un-convert the Roth IRA conversions, there’s a strategy intrinsic to Roth IRA conversions that will have the effect of minimizing the amount of tax paid by the account holder. This strategy necessarily revolves around the assumption that the account holder is poised to convert the taxable portion of the traditional IRA
How Does It Work?
Below are the steps comprising a good plan to execute the Roth IRA conversion strategy
STEP # 1: Creating multiple traditional IRAs
Say a client has a $200,000 traditional IRA and wants to convert it, the first step is to separate it into four (4) $50,000 traditional IRAs.
Step # 2: Converting Individual IRA accounts
For each of these four accounts, recommend making a traditional IRA conversion to a Roth IRA, but at same time keeping each new IRA separate.
Step # 3: Diverse Investing
When it comes to these new Roth IRAs, taxpayers should take advantage of a more inherently flexible investment strategy, mainly separating these accounts by asset class.
Step # 4: Eying Returns
Returns will vary, of course, since each IRA owns a different asset class. The general rule of thumb is that when the value goes up, the taxpayer should sit tight.
Step # 5: Re-characterizing
Selecting the accounts with waning values is the next step. This could be all, some, or none, of the new Roth IRAs. At this point taxpayers should reverse the conversions with a “recharacterization” by the 15th of October, 2011.
(6) Voila — Tax Savings
With this strategy enrolled agents should enable holders to avoid paying taxes on money they’ve lost, circumventing the need to re-characterize the entire conversion, while permitting them to keep the conversions on the big winners
Further Tips
Re-convertion All the Way
Money that has been recharacterized can be reconverted at at later date without penalty. However, a 30-day waiting period is imposed. Reconverting at a lower value means lower taxes.
It’s Time to Rebalance and Consolidate
Once the conversion is done, taxpayers can reassemble the Roth IRAs back together as way of creating an easier record keeping system.
Tidying Up Records
Because the paperwork associated with the above strategy tends to get very complicated very fast, keeping good records is of paramount importance. The temptation is is to underestimate this recommendation until it is too late. Instruct clients not to fall victim to this pitfall.
It’s About Good Communication
If a taxpayer has multiple accounts, enrolled agents should advise clients to work closely with their brokers to ensure that conversions and recharacterizations are done accurately.
IRS Circular 230 Disclosure
Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.