It’s been tough out there lately. Want to bring somegood news to your clients? Down markets may makethis a good time to convert a traditional IRA or aqualified plan lump sum to a Roth IRA. Why? Because when a client converts a retirement accountto a Roth IRA, they are taxed on the value. If that valuehas fallen, so will the income taxes. And Uncle Sameven gives clients a chance to “do over” a conversion, if values continue to fall after the original conversion.

Why a Roth IRA?There’s a lot to like in a Roth IRA. While distributionsfrom a traditional IRA are usually fully taxable, Roth IRAs allow for tax-free qualified distributions.And, because Roth qualified distributions are notadded to income, they will not boost your client’sadjusted gross income (AGI) like traditional IRAdistributions will. A lower AGI has a ripple effect ontaxes. For example, a lower AGI can mean less of yourclient’s Social Security benefit is subject to tax. A lowerAGI means it will be easier to get over the 7.5%-of-AGIthreshold for deductible medical expenses or the 2%threshold for miscellaneous itemized deductions. Thephase-out of personal exemptions and itemizeddeductions is also keyed to a higher AGI.

Qualified distributionsHow does your client get a tax-free distribution from their Roth IRA? They need to take a “qualifieddistribution.” A distribution from a Roth IRA is tax-free if they have had a Roth IRA open for five yearsAND if they take the distribution after 59 ½, if they take it because of death or disability, or if theytake up to $10,000 for a first-time home purchase. If their distribution is not a qualified distribution, then see our Q & A referenced below for anexplanation of the rather complicated tax scheme.

In addition, Roth IRAs need not pay out requiredminimum distributions during the owner’s lifetime.The owner can accumulate the funds for life if they wish,and leave a tax-free Roth IRA for their beneficiaries.

Converting to a Roth IRAA traditional IRA can be converted to a Roth IRA. Recent law also allows a person to convert a qualifiedretirement plan directly to a Roth IRA without firstrolling over to a traditional IRA. Of course, the clientmust have a distributable event to take funds fromtheir qualified plan – typically because of reaching 59 ½or separating from service. Also, the qualified planmust allow for the conversion directly to the Roth IRA.

The client must meet two requirements to be eligibleto convert to a Roth IRA. First, the client’s ModifiedAdjusted Gross Income (MAGI) must be less than$100,000 (regardless of whether the client is filingjointly, head of household, or single). MAGI is generallyAGI, but not including the Roth conversion itself. The second requirement is that the client cannot havethe filing status of “married, filing separately.”

The client must include the value of the conversion in income, and pay income tax on it. For an annuity,the value is generally the cash value plus the actuarialpresent value of any additional living or death benefits.Note that including the conversion in income willspike the AGI for the year, which might have negativeripple effects on taxes, as described above. If the clientwere to take part of the conversion funds to pay thetaxes, it would hurt the economics of the conversion. It is best to pay the taxes from outside funds.

Roth IRA conversions, recharacterizations, and reconversionsAllianz Life Insurance Company of North America

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2010: Roths available for more peopleRoth IRAs will continue to be a hot topic for 2009 and2010. That’s because Congress recently passed a lawto lift the obstacles for converting to a Roth IRA.Beginning in 2010, even people with MAGIs above$100,000 or people who are married, filing separatelywill be able to convert to a Roth IRA. In addition, if theyconvert in the year 2010 (only 2010), they can defertaxes for a year and then spread the tax over tax years2011 and 2012. Spreading the taxes could potentiallyreduce their overall tax rate on the conversion. If youhave a client who wants to convert to a Roth IRA but isineligible, plan for a 2010 (or later) conversion. Have them save now to make sure they have theliquidity to pay the taxes without having to dip into theconverted funds.

RecharacterizationWhat happens if your client converts today but thevalue of the Roth IRA falls? They will have paid tax onmoney that disappears. For example, suppose Fayconverted her traditional IRA to a Roth IRA in February2008 when its value was $50,000. She has to includethat $50,000 in income tax. But then the credit crunchhit Wall Street, and now her IRA is worth only $30,000. She doesn’t want to pay tax on $50,000 when the valuetoday is only $30,000. Fortunately, Uncle Sam will allowher to undo the transaction.

Your client can “recharacterize” a Roth conversion back to a traditional IRA. The recharacterization treats the transaction as if the original conversionnever happened. After they recharacterize the Roth IRA to a traditional IRA, there is no need to pay tax on the conversion.

A calendar-year taxpayer can recharacterize untilOctober 15 of the year after conversion. For example, if a taxpayer converted to a Roth IRA in 2008, they haveuntil October 15, 2009 to recharacterize thatconversion back to a traditional IRA. Even if thetaxpayer already filed a 2008 tax return, they canrecharacterize and file an amended 2008 return.

ReconversionSuppose Fay still likes the idea of a Roth conversion,but she just doesn’t want to pay tax on value thatdisappeared. After she does the recharacterization, Fay can reconvert to a Roth IRA a second time. The taxpayer who wants to reconvert will have to waituntil the next calendar year after the originalconversion or, if later, 30 days after the recharacterizationto reconvert. So someone who converts in May 2008and recharacterizes in February 2009 has satisfied the“calendar year after the original conversion” test, andnow must wait until 30 days after the recharacterization.Someone who converts in May 2008 and recharacterizesin October 2008 has to wait at least until 2009 toreconvert. Hopefully, the risk will pay off and the valuewill stay low until the reconversion.

Roth IRAs for the wealthyRoth IRAs may be especially attractive to wealthyclients with taxable estates. A Roth IRA owner doesn’thave to take any RMDs during their lifetime. They cansave the entire IRA for their children or grandchildren.It also helps in estate planning. A wealthy Roth IRAowner pays the income tax when they convert. This isa real economic benefit to the children or grandchildrenwho will inherit the qualified distributions from theRoth IRA, because it cuts their future tax burden. Yet paying the tax is not considered a taxable gift tothe beneficiaries and will not use any of the parent’s$2,000,000 ($3,500,000 in 2009) estate and gift taxapplicable exclusion amount.

Allianz can helpRoth IRA conversions are a bright spot amid the dimfinancial news of today. They can give you a positiveidea to present to your clients. Uncle Sam has takensome of the risk out, too, by allowingrecharacterizations and reconversions.

Allianz offers you several resources to help you understandRoth IRAs. Ask your Sales Desk representative for:Q &A Converting to a Roth IRAQ & A Roth IRA distributions(Both of these can be found in our Advance Markets Q & A book, Third Edition.)

You can also speak to one of our tax specialists by calling theSales Desk and asking for the Advanced Sales phone line.

This document is designed to provide general information on the subjects covered. Pursuant to IRS Circular 230, it is not, however, intended to provide specific legal or tax advice and cannot be used to avoid tax penalties or to promote, market, or recommend any tax plan or arrangement. Please note that Allianz Life Insurance Company of North America, its affiliated companies, and their representatives do not give legal or tax advice. Encourage your clients to consult their tax advisor or attorney.

Not FDIC insured • May lose value • No bank or credit union guarantee • Not a deposit • Not insured by any federal government agency or NCUA/NCUSIF

Allianz Life Insurance Company of North America, 5701 Golden Hills Drive, Minneapolis, MN 55416-1297. www.allianzlife.com

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