Sure, it's summer and the living is easy, but it's not too early to begin thinking about the 2009 tax strategies that will enable your clients to minimize what they hand over to Uncle Sam.
In addition to evergreen pointers like maximizing contributions to qualified retirement plans and harvesting portfolio losses, the down market and new tax credits have created a silver lining in the current financial cloud that's worth exploring.
I spoke with Brett Ellen, CFP, president and CEO of American Financial Network, Calabasas, Calif., to get his thoughts. Here are five timely tax tips that can deliver extraordinary long-term benefits.
1. Convert a traditional IRA to a Roth IRA.
If you and your clients have discussed the benefits of converting a traditional IRA to a Roth IRA where qualified withdrawals are tax free, many likely balked at the cash outlay to pay conversion taxes.
Ellen points out, however, that as many investment accounts have declined in value over the past year, clients who convert this year will owe less tax than they might have in the past. The extra bonus is that their new Roth will capture gains from the market's eventual rebound on a tax-free basis.
"Of course we expect the market to recover – just look what it's done so far this year, all with no money coming off the sidelines," he says. "Clients understand the benefit of buying investments cheap and having them appreciate as the market recovers, but when they convert to a Roth, the bonus is they will withdraw those appreciated assets tax free at a time in the future when it's likely the tax rate will be higher than it is today.
"Let's say a client moves $400,000 to a Roth and it's worth $1 million 10 years from now. The $70,000 paid in taxes to convert could create an account that could support a tax free annual withdrawal of $70,000 to $80,000 for 20 years," Ellen says.
While those tax savings would far exceed the initial tax paid to convert, Ellen notes that for some clients a combination of investment strategies and planning techniques can enable them to avoid paying taxes on the Roth conversion.
For example, Ellen is working with 61 year-old client with a $700,000 traditional IRA and a house worth $300,000. She owes only $50,000 on her home and although the monthly mortgage payments are low, she is frustrated by high taxes.
Ellen recommended taking out a $120,000 loan for 30 years to increase mortgage interest deductions from $2,000 to $7,000. Additionally, he's using a combination investment tax credits and passive losses from her rental property to move approximately $40,000 a year form her traditional IRA to a Roth with zero tax, with the goal of converting $400,000 over a ten-year period.
This year, clients can convert their traditional IRA to a Roth IRA if their modified adjusted gross income (MAGI) is under $100,000. Note, however, that the income cap is scheduled to disappear in 2010, courtesy of the Tax Increase Prevention and Reconciliation Act of 2006. After 2010, there are no income limits for a conversion.
2. Take full advantage of the $8,000 credit for first-time homebuyers.
If your client is in the market for their first home, falling real estate prices and low interest rates are obviously good news. Additionally, the American Recovery and Reinvestment Act of 2009 authorizes a tax credit equal to 10 percent of the home's purchase price up to a maximum of $8,000 for qualified first-time home buyers purchasing a principal residence on or after January 1, 2009 and before December 1, 2009.
While that should excite your clients, Ellen advises investing the $8,000 saved into a Roth. "The best time to get into a Roth is when you are in a low tax bracket, but younger clients don't generally have a traditional IRA they can convert," Ellen explains. "I suggest first-time homebuyers who get the credit and have a 401(k) plan that offers a Roth option, invest in the Roth instead of making pre-tax 401(k) contributions. Over 30 years, that $8,000 can grow into a healthy tax-free retirement account."
