Roth conversion could be for you
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By converting a traditional IRA to a Roth IRA, the account owner can leave assets to his or her heirs that will not have an inherent income tax liability. That means that when the heirs take distributions from the Roth IRA, they will not pay income tax. A Roth conversion can also be an effective estate-planning tool for an individual who anticipates having a taxable estate because the conversion enables the payment of income tax with assets from the estate, thereby reducing the eventual estate tax burden.
Recharacterization
Of course, there are risks associated with forgoing the tax-deferred status of IRA assets and accelerating the tax due. One risk of conversion - especially pertinent in the world of market volatility in which we currently live - is that an account balance will plummet after conversion. For example, if a $500,000 traditional IRA is converted in July of 2010 and by November of that year, the Roth IRA is worth only $400,000, the account owner will still have to pay tax on the full $500,000. In this example, there would be an income tax liability on $100,000 worth of value that eroded.
Thankfully, there is a mechanism to "undo" a conversion that is not successful -- recharacterization. A recharacterization is tantamount to treating the transaction as if the Roth conversion never occurred -- the retirement assets are returned to the traditional IRA and the payment of the conversion tax is avoided. There are tax reporting obligations and certain limitations on the timing of a recharacterization, so make sure to consult a tax advisor to ensure that the applicable requirements are satisfied.
If At First You Don't Succeed...
If an underperforming IRA conversion prompted a recharacterization of the initial conversion, there still might be a chance for a second bite at the apple. An IRA owner is permitted to make another conversion of the same traditional IRA assets to Roth IRA assets on the later of (1) the tax year following the original conversion, or (2) 30 days after the recharacterization.
Explore the Possibility
The decision about whether to convert (or to recharacterize or reconvert, for that matter!) is a complex one that must take into account many factors. If you would like to employ some of the retirement-planning strategies discussed in this article, Roth conversion might by an opportunity worth exploring.
Sarah Marks is an attorney with the Private Client Group at Holland & Hart LLP and focuses her practice in wealth transfer, tax and estate planning, and charitable giving. She also has experience practicing in the area of employee benefits, ERISA, and executive compensation. Sarah can be reached at 303-295-8470 or shmarks@hollandhart.com.
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