By KAREN HUBE and BRIDGET O'BRIAN
Staff Reporters of THE WALL STREET JOURNAL
Some of the nation's top earners are doing financial acrobatics trying to
reduce their adjusted gross income to $100,000 or less this year.
That would seem out of character, except that there is a method to this
madness. Their goal: to convert their traditional individual retirement accounts
to Roth IRAs -- and nail down significant retirement- and estate-planning
advantages that were designed for more-modest earners.
These affluent folks, including some with incomes in the high six figures and
even seven, are finding creative, and legal, ways to report much less to the
Internal Revenue Service. Many are rushing to convert before year end,
because according to Roth IRA rules, 1998 is the only year investors are
allowed to spread taxes on converted assets over the next four years.
"Some people are jumping through hoops to qualify," says Michael Hartlett, a
financial planner in Lancaster, Pa. "For many baby boomers this is a big
issue."
Mr. Hartlett has taken his own advice, pushing his adjusted gross income to
below the $100,000 threshold that the IRS says is the cutoff for those who
want to convert their IRA to a Roth. A 50-year-old owner of his own
financial advisory business, Mr. Hartlett stopped drawing income earlier this
year and has been borrowing money from his firm to cover his living
expenses. Later, he will have his company forgive the loan, a move that
makes the money subject to income taxes. And, he says, "I may forgive that
note over a number of years so I can control the tax burden."
Meantime, the taxes he owes on the IRA assets he has converted this year
can be paid over four years. Had he waited until next year or any time after
that to convert, he would have to pony up all the taxes at once.
The main advantage of converting to a Roth is that "any earnings within that
Roth IRA from now until it's done are totally tax-free," says John Gardner, a
senior manager in the personal financial practice in Washington, D.C., for
KPMG Peat Marwick. After the conversion, it becomes, essentially, "like a
tax-exempt investment."
In a traditional IRA, contributions are usually tax-deductible and assets grow
tax-deferred. By contrast, investors can't deduct contributions to a Roth, but
the money grows tax-free. Roth earnings can be withdrawn tax- and
penalty-free as long as the investor is at least 59 1/2, and has held the account
for five years. Money converted from a regular IRA and held in a Roth IRA
for at least five years can be withdrawn at any time tax- and penalty-free, no
matter what the investor's age.
There are tremendous perks when it comes to estate planning. For one thing,
investors in a regular IRA are forced to take distributions after they turn 70
1/2; With a Roth, there is no requirement that an investor withdraw money --
ever. "Roth investors can potentially leave much more for heirs," says Stewart
Welch III, a financial planner in Birmingham, Ala. Moreover, heirs don't have
to pay taxes on inherited Roth assets, as they would with a traditional IRA,
because with a Roth IRA those taxes have been prepaid.
All this adds up to an enormous benefit for the wealthy, who frequently have
six- and seven-figure IRAs and sizable estates, and are always seeking to
reduce the tax burden on both. It isn't easy for them to winnow down their
income to qualify for the conversion, though.
To be sure, not every wealthy investor can take advantage of the Roth
conversion. "If you are working for a company, and your wages are in excess
of $100,000, there's not a lot you can do. But if you own your own business,
or you're retired, or you're in a business where you can take payments later
on after Jan. 1, clearly there's a little bit of planning that can be done," says
KPMG's Mr. Gardner.
The people with the most flexibility are business owners, particularly those
whose companies are set up as C corporations, because they can decide
when they want to recognize income, says James Budros, financial planner in
Columbus, Ohio.
Advantages to business structures such as a sole proprietorship, S
corporation, partnership or limited liability company, are that owners can take
some significant deductions for business-related expenses, including as much
as $18,500 for purchases of business equipment. These deductions can be
used to reduce individual income.
"If you really want to be shrewd, you could on Dec. 31 spend $18,500 on a
credit card," says Ed Slott, publisher of Ed Slott's IRA Advisor in Rockville
Center, N.Y. "The interest on the credit card is also deductible" in the year it
is accrued.
However, avoid using other business deductions aggressively to reduce
income, advises Mr. Slott. If these expenses are disallowed by the IRS later,
and your income turns out to have been above the $100,000 limit in the year
you converted, you would be in the appalling position of having to pay back
taxes, interest and penalties.
Some wonder whether all these gyrations are worth it, or even legal.
Absolutely, says Mr. Hartlett. "It's entirely legal ... You're not beating the
system entirely, all you are doing is shifting income to take advantage of the
Roth."
