Caution: Two-Year Tax Trap for Roth IRA Conversions Ahead!

In the financial world, two years can be a very long time during which markets can fluctuate wildly. We only need to look over our shoulders to the past 24 months for validation. So one question CPAs and financial professionals should be asking today is “What should I be doing for my clients during the two years from their Roth conversions?”

Converting is not without risk. And this two-year “waiting period” for clients to pay their tax liability is a critical time (assuming they opted to pay the conversion tax over the two year period vs. in 2010 tax year). “Protecting the Roth IRA from a catastrophic decline in value during the two year spread should be a CPA’s focus,” explains Robert Keebler, CPA, MST, AEP and partner at Baker Tilly. “The main risk here is that the Roth IRA could decline to a value lower than the tax liability owed on the 2010 Roth IRA conversion. CPAs and tax advisors need to compare deferring the taxable income over 2011 and 2012 and paying income tax at higher rates against paying the income tax in 2010 at lower income tax rates.”

Getting Around the Two-Year Tax Trap

Describing this as “the two-year tax trap,” Keebler shares the following strategy to help cushion a potential account-value fall. “Assume your client Jackie converts $1,000,000 of her traditional IRA to a Roth IRA in 2010. If Jackie pays the tax over 2011 and 2012 and is in the highest tax bracket in both years (i.e. 39.6%), her total tax liability will be $396,000.

“Since she is in a higher tax bracket, Jackie will want to pay a ‘protective’ estimate in 2011 based on her 2010 tax liability (unless her 2011 tax liability will be lower) and then pay the remainder of the tax when she files her 2011 tax return,” suggests Keebler. “For 2012, Jackie will need to pay a ‘protective’ estimate based on her 2011 tax liability (unless her 2012 tax liability will be lower).”

The key point is that if the Roth IRA declines in value to below $396,000 after October 15, 2011, Jackie will still be responsible for paying the entire tax liability. Keebler notes that in addition to any higher risk investments, it will be important for Jackie to create a “reserve” (e.g. buy put options, invest in CDs, etc.) in her Roth IRA to protect against a catastrophic decline in value.

Avoiding the Trap At the Get Go

Even before the conversion, CPAs and advisors can help lessen their client’s likelihood of falling in the two-year tax trap by determining a strategy for the conversion. This may include implementing a multi-account strategy upon converting to a Roth IRA to provide clients with more flexibility over the course of the two years. The actual tactics of the number of accounts, setting up by asset classes and/or level of risk varies, but the end goal remains being able to recharacterize just the Roth IRA(s) with an investment that has declined. So in the case of Jackie in the example above, “If the account declines significantly before October 15, 2011, Jackie should recharacterize the Roth IRA conversion (thereby eliminating the tax liability),” says Keebler.

Not only is the “two-year tax trap” hard to say three times fast, your clients will trip if you aren’t watching out for it. Here are a few additional resources to help you steer clear of potential hazards and assist you with your Roth IRA conversion planning:

Robert Keebler references to additional resources:
• The new AICPA book The Rebirth of Roth: A CPA’s Ultimate Guide for Client Care is due the end of December. To learn more about the book or place an order, please call the AICPA customer service hotline at 1-888-777-7077.
• 100+ Roth Examples and Flowcharts contains an extensive set of examples pertaining to Roth IRAs and the intricacies of this investment vehicle. Edited by Barry Picker, these 100+ examples are a great tool to aid in the comprehensive and expansive rules related to Roth IRA contributions and conversions. To learn more about the book or place an order, please call Picker & Auerbach customer service hotline at 1-800-809-0015.
• Now available is CCH’s Roth IRA Conversion Expert™ . This software provides tax practitioners with comprehensive Roth IRA analysis and implementation guidance to convert a traditional IRA to a Roth IRA successfully and efficiently. For more information on the Roth IRA Conversion Expert, please contact CCH customer service hotline at 1-888-224-7377 or go to http://tax.cchgroup.com/findrep/findrepresearch.
• For additional Roth IRA Conversion webinars hosted by Robert Keebler and Equity Trust, CPAs, attorneys and financial professionals may register for the Equity Trust Professional Network and Online Resource Center at www.trustetc.com/pronetwork.

Disclaimer: Equity Trust is a passive custodian and does not provide tax, legal, or investment advice. It does not endorse or recommend any contributor, company, or specific investments. Any information communicated by Equity Trust Company is for educational purposes only and should not be construed as tax, legal, or investment advice. Whenever making an investment decision, please consult with your legal, tax, and accounting professionals.