PLANS LEGACY GIFT FOR EXPAT

Wednesday, December 29, 2010

By Steven Wightman, CFP®

The retirement genie is out of the bottle again this time changing a taxable traditional IRA to a tax-free Roth IRA. So what you say? Anyone can convert in 2010 because there is no income requirement. True, but can this genie converted with no tax consequences now or ever.

Those converting before midnight 12/31/2010, unless they have an offsetting loss will be taxed on the conversion amount. However, they may elect to pay the tax triggered by converting a traditional IRA to a Roth IRA over a two year period; half in 2011 and the other half in 2012.

Joe, an Expat with no taxable US income since 2008 asked me to convert all his retirement plans to non taxable status and pay little or no tax on these transactions. We hatched a plan that went like this:

1. We converted his company 401k to a traditional IRA.
2. We created two Roth IRAs to split beneficiaries so as to avoid squabbles after Joe’s death.
3. We calculated Joe’s tax-free capacity so that he would pay no tax.
4. We converted a little less than this amount each year to his Roths.

Turning Bad Luck into Good Fortune:

Joe had seen his retirement nest egg shrink in 2008 and 2009. Further his employment vaporized and at age 60 his prospects for a job looked a lot like a mirage in the Sahara. Single and up against a wall, he took a fresh look at his life and skill set. He opted to teach ESL in a foreign land and live cheaply. Within months he landed a job in Mexico and he was off to a new life – complete with a bed, tortillas and an ability to save again.

Taxing a chick Instead of a Chicken: His shrunken portfolio saved him money. At one point we discovered that his retirement funds were only worth about 65 cents on the dollar compared to a high two years prior. “Joe”, I said, this is when you want to convert to a Roth because this asset allocation is likely to bounce back to even surpass what it was at its peak, but if you convert now you only pay tax on the conversion amount, 65 cents instead of a dollar or would be future dollars. However you will pay NO TAX unless some of those dollars exceed your tax capacity. “What do you mean tax capacity?” he said. I explained: “Once you add your personal exemption and itemized deduction together you get to $9,800 in 2010. Only dollars exceeding that threshold are taxable. In addition, you can add any tax credits and even stock losses from stocks sold (capital losses) to this amount within certain limits. This means that you may convert lots of dollars each year and a large percentage of your retirement funds tax-free and one day this may add up to a legacy fund for you.”

Conversion convert: He learned that if these funds grow as expected over the next eight years when he plans to retire at age 70, they will double in value to some number much bigger than the 100k he converted. He was sold.

In January 2011, Joe converts the fourth tax-free batch of funds to his Roth IRA. If he does this for all ten years to retirement from 2008, he will convert over $100,000 and pay no taxes on it for the rest of his life. Note that his minimum tax capacity will increase over the years as the standard deduction and personal exemption also increase. With an anticipated future tax rate of at least 15%, Joe could use these savings to purchase a car or a long postponed dream vacation.

Disappearing from the IRS? What would it be like to have six digits of tax-free cash in your retirement plan? Joe mused that converting what once was his 401k plan to a tax-free growth and income Roth and never pay any tax on it was, well, a genius plan – even if it was his brother who suggested it. I just couldn’t dream up a better holiday gift. It sure beats those white elephants and he doesn’t have to dust it.