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TAX BUSTERS 2010 Roth IRA Conversions and Muni Bonds Leon LaBrecque, JD, CPA, CFP®, CFA Reducing Uncertainty™

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Two techniques to combat a rising tax environment: Roth IRA conversions and Muni Bonds

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Page 1: Tax Busters

TAX BUSTERS 2010Roth IRA Conversions and Muni Bonds

Leon LaBrecque, JD, CPA, CFP®, CFAReducing Uncertainty™

Page 2: Tax Busters

LJPR, LLC 210/14/2010 Copyright© 2010, All Rights Reserved.

Why Tax-Busters?

• Nightmare on C Street:– Lame Duck Congress– 20 Bills

• Three possible scenarios– Extension– Amendment– Expiration

Page 3: Tax Busters

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Lame Ducks

• Defense authorization bill• DREAM act for illegal

immigrant• Extension of unemployment• Freeze on Medicare

reimbursements• Renewable energy standard• START Arms Treaty• EPA carbon emissions• Oh yeah, taxes

Page 4: Tax Busters

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Tax Expiration & Health Care Bill = ???

• Expiration of tax cuts raises all rates

• 2013 add 3.8% surtax on interest, dividends, capital gains to upper brackets– Over $250K MAGI for

MFJ– Over $200K MAGI for

Single

Page 5: Tax Busters

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Tax Busting Strategies

• Higher Brackets affect:– IRA and 401(k)

distributions– Investment income on

taxable accounts

• Roth conversions:– No income tax on

investment return– No RMD

• Michigan muni bonds– Federal tax free – Michigan tax free

TAXBUSTERS

Page 6: Tax Busters

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Roth IRAs

• Three types of IRAs:– Deductible (contributions and earnings are tax-deferred)– Nondeductible (earnings are tax-deferred)– Roth (income is tax-free)

• Roth, Roth 401(k) (DRAC)• Roth qualifying distributions are tax-free

– 5 years or age 59 ½, or– Death, disability, qualifying special purpose distribution

Page 7: Tax Busters

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Roth Basics

• No Required Minimum Distributions (age 70 ½ )• Conventional IRA investment choices (virtually

unlimited)• Qualifying Roth distributions excluded from:

– Computation of taxation of Social Security benefits– Medicare Part B premium (need based calculation)

• FIFO withdrawals• Earned income requirement for contributions• Not included in MAGI for Health Care UIMC

Page 8: Tax Busters

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Contributions

• Lesser of earned income or:– $5,000 (under age 50)– $6,000 (turning 50 or older in year of contribution)

• AGI Limits– MFJ: $166,000 - $176,000 (phase out)– Single: $105,000 - $120,000 (phase out)

• AGI Limit Loophole: Nondeductible IRA for 2009 and 2010, then convert (Aggregation rule)

• Rollovers from 401(k), 403(b) and 457 allowed

Page 9: Tax Busters

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Conversions

• Existing Traditional IRAs can be converted to a Roth IRA by paying the tax on the fair market value of the taxable portion.

• Job Bill now allows internal 401(k) conversion• Beware of tax bracket creep.• Conversions can be recharacterized (so can

contributions)• 2010 conversions have no income limit• 2010 conversions have two tax options:

– Pay all tax in 2010– Split income equally between 2011 and 2012

Page 10: Tax Busters

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To Split or Not to Split?

• Splitting is automatic: you have to split income on Roth conversions in 2010 unless you elect otherwise by paying the tax.

• One spouse can split, one can pay in 2010• If your income and rates stay the same, you save

taxes by splitting.• Example: Married Couple over 65, standard deduction. They have

income in 2010 of $89,900 before any Roth conversion. They convert $300,000 in 2010. They can elect to pay the entire tax on the conversion in 2010, which would be $93,219. Otherwise, they would split the taxes over 2011 and 2012 and pay $40,380 in each year. This saves $12,459 in taxes, plus the time value of money, since they pay no taxes on the conversion in 2010, and spread the $40,380 over the next two years.

Page 11: Tax Busters

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Recharacterization

• Tax Mulligan. You can reverse a conversion by putting the funds back into the Traditional IRA.

• Can recharacterize once a year (30 day rule), per Roth conversion.

• Timeline for recharacterization:– 10/17/11 for 2010 conversions if return is timely filed

or extended;– 04/15/11 for 2010 conversions if return is filed late

and not extended.

Page 12: Tax Busters

LJPR, LLC 1210/14/2010 Copyright© 2010, All Rights Reserved.

Who Should Convert?

• Taxpayer in the same or higher bracket at distribution time:– Other income sources– RMD considerations

• Taxpayer’s Heirs– Spouse (RMD and filing status)– Children and grandchildren

• Estate Tax situation• Unneeded RMDs (must be taken before

conversion)

Page 13: Tax Busters

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RMDs

• Roth IRAs are not subject to RMDs.• RMD calculation has a decreasing denominator.• RMDs shift the taxpayer’s bracket higher if the

rate of return is higher than the initial withdrawal rate.

• RMDs, if unneeded, are merely a tax burden at the highest marginal bracket.

Page 14: Tax Busters

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The Unneeded RMD Conversion

• You must take an RMD before conversion• This strategy used the remaining unneeded

RMD to pay the taxes on a Roth conversion

$585,000IRA

$23,684RMD

$6,951 tax

$16,733 net

$57,011Roth IRA

Note: In the second year, given 7.5% growth, the Regular IRA would bedown to $546,403, and the Roth would be up to about $61,000.

Page 15: Tax Busters

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Higher Brackets

• Taxpayers can be in a higher bracket by virtue of RMDs.

• The death of a spouse leaves the other in the higher single bracket.

• Example: Older couple, C&D, over 70 ½, same age. Have income consisting of primarily IRA distributions from their rollover IRAs, plus Social Security. Income for both with Social Security is about $156,000. They take standard deduction. Total Federal tax is $26,687. C dies, D loses C’s Social Security of $15,000 (taxable portion). D’s income drops to $141,000. However, now she is single (lower standard deduction, one less exemption and higher bracket). Her tax would go up to $30,571; $3,887 more. Roth conversion helps the surviving spouse.

Page 16: Tax Busters

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Higher Brackets: Kids

• Another scenario is a parent in a low bracket with successful kids in a higher bracket.

• Example: mom or dad with basic pension and Social Security. RMDs are unneeded and also are forcing the Social Security to be taxed (possible Medicare B premium as well). Kids are in high brackets. Convert and reduce taxes, plus pass tax-free annuity to kids.

• Don’t forget grandkids (and don’t forget GST).

Page 17: Tax Busters

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Estate Tax

• Current estate tax situation requires a food taster for the well-off. (No tax in 2010, then $1M and 55% in 2011).

• Probable outcome is a $3.5M exclusion and 45% rate (possible $5M and 35%).

• Roth conversion reduces estate taxes by the income tax paid on the conversion.

Page 18: Tax Busters

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Estate Tax Example

• Bill has an estate worth $4M, of which $1M is in an IRA. He dies (and estate exclusion goes to $3.5M), leaving estate to kids. Kids pay $225,000 of estate taxes and will pay income taxes on the $1M IRA (with a prospective income tax deduction of IRD of $225k). If he converts IRA to Roth, he pays $350,000 in income taxes. Estate taxes are only $67,500 and kids get $1M Roth IRA tax-free. $531,900 total taxes (if kids are in upper bracket) on traditional IRA, versus $417,500 with Roth conversion.

Page 19: Tax Busters

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More Estate Issues

• Roth conversion provides a tax-free annuity for children or grandchildren.

• GST could be minimized or eliminated with an IRA trust– Accumulation Trust– Income Trust– Formula in Trust

• Charity illogical• QDOT

Page 20: Tax Busters

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Segregated Roth Conversions

• Multiple Mulligan opportunities by converting multiple Roth’s.

• Recharacterization can only be done once a year, so having multiple Roth IRAs allows for selective recharacterization.

• Vertical segregation would allow asset picking– Individual securities– Asset classes

Page 21: Tax Busters

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Conversion Example

02/03/10 12/10/10

One Roth worth $308,000No recharacterization,

tax on $280,000. $28,000 tax-free gain

Traditional IRA280,000

Roth Conversion

IRA

Roth Conversion IRA

308,000

Page 22: Tax Busters

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Segregated Example

02/03/10 12/10/10

6 Roth's worth$ 248,800, 2 recharacterizations, tax on $210,000. $38,800 tax-free gain

Traditional IRA280,000

LC$42,000

IGF$28,000

SC$42,000

GFI$28,000

ILC$42,000

FHY$28,000

EM$42,000

EMI$28,000

LC$51,000

IGF$29,400

SC$52,000

GFI$29,400

ILC$52,000

FHY$33,000

EM$34,000

EMI$25,200

EM$34,000

EMI$25,200

Page 23: Tax Busters

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What Can Go Wrong?

• Congress could eventually tax Roth IRAs– Necessity of proactive law– Income tax– VAT or excise tax would tax distributions (and

everything else) on consumption.

• Congress could prohibit or limit conversions.

Page 24: Tax Busters

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• Muni bonds are tax-free– Federal and state (if Michigan bonds)

• Types of munis– General obligation (GO), secured by tax revenues

• Limited Tax GO• Unlimited tax GO

– Revenue, secured by revenue stream, like sewer and water– Private-use provide a service with a private function,

riskier– Insured, Principal and interest guaranteed by an insurer

(junk question)

Michigan Muni Bonds

Page 25: Tax Busters

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• Since munis are tax-free, their yield can be measured against a taxable investment using a formula.

• TEY = [i/(1-t)], where i is the bond’s yield, and t is the tax rate

• So for a low bracket taxpayer (15% fed/4.35% MI), a 4% MI muni might have a TEY of 4.96%

• High bracket (35% fed/4.35% MI, TEY might be 6.53%• Health Care Act and tax increases, maximum fed and

Michigan rate goes to about 46%, and the TEY on a 4% bond is 7.31%

Taxable Equivalent Yield

Page 26: Tax Busters

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Overpricing of Risk

• Wall Street is pricing all of Michigan as if it will default.

• Not all areas of the state have the same financial stresses: Ann Arbor is different from Detroit. Traverse City is different from Flint.

• Different issues have different risk profiles. In the old days, we read the official statements. Its time to do that again.

• Rating Agency woes and lack of credibility.

Page 27: Tax Busters

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Insurance: Ain’t What it Used to Be

• Muni insurers are in worse shape than the municipalities

• Many insurers are junk status

• Insurance is not a guaranteed safety net

• Insurance is nice, but read the issue

Page 28: Tax Busters

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Tax Free Income

• Tax increases make munis more attractive

• Health Care bill adds 3.8%

• Complex rules on discount munis

• AMT bonds

Page 29: Tax Busters

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Interest Rate Environment

• Yield curve is in unique formation (excessively steep).

• Short term rates are at very low rate (for now).• A low duration (short term) portfolio provides

low inflation risk.• Duration is the key to maximize return and

reduce risk.• Yield spreads on munis are historically high.

– Usual is 85% of Treasuries– Currently about 115-120%

Page 30: Tax Busters

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Key Factors

• Quality is paramount: Know what you are buying.

• Liquidity is at a premium. Municipalities need money and there's competition for investment dollars.

• Value in the market– “Fire Sales” can be found– Smart buying enhances return– Exploit the bid /ask spread

• No Central exchange for munis

Page 31: Tax Busters

LJPR, LLC 3110/14/2010 Copyright© 2010, All Rights Reserved.

Bottom Line

• Tax rates are probably increasing• Roth IRAs are tax free

– Conversions may pay tax at current rate– Conversions may be reacharacterized

• Roth's are tax free to beneficiaries• Michigan munis have mispricing of risk• Munis are tax-free for both federal and state

purposes

Page 32: Tax Busters

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Bottom Line

• Higher tax rates make munis more attractive.

LJPR, LLC4555 Investment Drive, Suite 304

Troy, MI 48098

248.641.7400

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