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Planning for a Roth Legacy

Maximizing Flexibility and

Minimizing Income Tax

0160901-00002-00 Ed. 10/20091

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This is being provided courtesy of The Prudential InsuranceCompany of America, Newark, NJ, for its licensed financialrepresentatives and clients’ advisors. It provides generalinformation in regard to the subject matter covered. It ispublished with the understanding that Prudential is notproviding legal, accounting or tax advice. Such servicesshould be provided by the clients’ own advisors. Accordingly,any information in this document cannot be used by anytaxpayer for purposes of avoiding penalties under the InternalRevenue Code.

Securities and Insurance Products: Not Insured by FDIC or Any Federal Government Agency.

May Lose Value. Not a Deposit of or Guaranteed by Any Bank or Bank Affiliate.

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Life insurance issued by The Prudential InsuranceCompany of America, Newark, NJ, and its affiliates. Lifeinsurance policies contain exclusions, limitations,reductions in benefits and terms for keeping them in force.Your licensed financial professional can provide you withcosts and complete details.

Prudential, Prudential Financial, the Rock logo, and the Rock Prudential logo are registeredservice marks of The Prudential Insurance Company of America and its affiliates.

Why Are Roth IRAs Hot?

Prepay income tax at today’s rates

Income tax-free withdrawals when requirements are met

No required minimum distributions

Transfer income tax-free wealth

No income limit on conversions after 2009

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Statistics

IRAs are the largest repository of retirement savings in the U.S.

Assets in IRAs at end of 2007: $4.75 trillion*

About 90% of this in traditional (taxable) IRAs*

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*Source: http://www.ebri.org/pdf/notespdf/EBRI_Notes_09-2008.pdf

Statistics

Over 2.5 million individual tax returns filed in 2006 (the most recent year for which stats available) were taxed at:

►the highest marginal rate 35% or

►the second highest marginal rate 33%*

6* Source: http://www.irs.gov/pub/irs-soi/06in34tr.xls

Statistics

Trillions of dollars are in traditional IRAs

Obama administration has proposed rate increases after 2010:►35% rate to 39.5% ►33% rate to 36%

Estimated 2.5 million Americans affected

Ability to prepay at 2010 rates could result in significant savings

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Overview: Planning for a Roth Legacy

Roth IRA and Roth 401(k) basics

Conversions, recharacterizations,and distributions

2009 opportunities

When converting makes sense

Wealth transfer opportunities

Integral role of life insurance

Beneficiary planning issues

FAQs

Case study

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Roth IRA Basics

No age limit – unlike traditional IRA, which allows no contributions after age 70½

Being covered by another plan does not affect ability to funda Roth

Contributions up to lesser of $5,000 or compensation(W-2, box 1) income; $1,000 catch-up if 50 or over;one limit for all IRAs (Roth or Traditional)

Maximum contribution phases out in 2009 at MAGI over $166,000 (married filing jointly) or $105,000 (single).These limits continue after 2009.

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Roth IRA Basics

Who can convert to a Roth IRA?►In 2009, modified adjusted gross income (MAGI) must be under

$100,000, whether married or single►Generally, must not be married filing separately Individual in process of divorce who has lived apart from spouse

the entire year can treat self as single►In 2010 no income limit no married filing separately limitation

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Roth IRA Basics

Modified Adjusted Gross Income (MAGI) for purposes of$100,000 limit only:

►Includes wages, commissions, fees for personal services, taxable alimony, earned income

►Does not include lifetime IRA RMDs►Does not include the amount being converted

Note that all these amounts are nonetheless includedas income for all other purposes!

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Roth 401(k) Basics

Roth 401(k) feature is an add-on, separate account (may also be Roth 403(b) account)

Holds after-tax contributions

Subject to one 401(k) elective deferral limit

No income tax on “qualified” distributions:►Five years of participation in the Roth account►Employee’s attainment of age 59½, disability or death

No income limits: available to taxpayers who make too muchto establish a Roth IRA

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Roth 401(k) Basics

“Qualified distributions” income tax-free

Requirements for “qualified distribution”►Five consecutive years of participation in Roth account, AND►Attainment of age 59½, disability, or death of participant►Note that hardship distributions and RMDs can be qualified

distributions if other requirements met

Note that five-year period is separate for each plan if participating in more than one plan

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Roth 401(k) Basics

Nonqualified distributions from a Roth 401(k):►Earnings subject to income tax and 10% penalty►Different ordering rules distributions do NOT come first from contributions as with Roth IRA;

basis is allocated to each distribution pro rata

Corrective distributions or income on them cannot be“qualified distributions”

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Roth 401(k) Basics

Roth 401(k) funds should be rolled over before age 70½ toavoid lifetime RMDs

Roth 401(k) funds can be rolled over only to a Roth IRA, another Roth 401(k)

Roth IRA can be newly created for this purpose even if income is above limit (new in 2009)

Rollover to Roth IRA allows for continued growth and results in tax treatment under Roth IRA rules

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Roth 401(k) Basics

Rollovers from Roth 401(k) to Roth IRA:

If 5-year period was not completed in the 401(k) plan and rollover is to a new Roth IRA, a new 5-year period begins

But if rolled over to existing Roth IRA, that IRA’s 5-year period applies – very beneficial

If rollover is a “qualified distribution” amount, it goes into the Roth IRA as basis.

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Comparing Features

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Contribution Limit (2009)

Eligibility(2009)

Application of5-Year Period

Events for Qualified

DistributionRMDs

required?Roth IRA

$5,000 plus $1,000 catch-up if 50 or over

Contributions: Under $166,000 or $105,000 Conversions: Under$100,000

One for all Roth IRAs, but calculated separately for conversions of nonqualified distributions

Attainment of age 59½, disability, death, first-time homebuyer (up to $10,000)

Not during life, only after death

Roth401(k)

$16,500 plus $5,500 catch-up if 50 or over

No income limits

Separate for each Roth 401(k) plan if participating in more than one

Attainment of age 59½, disability, death

Yes, both lifetime and after death

Roth IRA Conversions

Roth IRA conversions are technically known as “qualified rollover contributions”

This means that amounts that are not eligible for rollover cannot be converted, for example:

►RMDs►SIMPLE IRA distributions during 1st two years►Corrective distributions

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2010 Conversions: resulting income tax can be paid over 2011 and 2012, half each year

Default is 2-year spread, no inclusion in 2010, but taxpayers may opt out of this treatment. If rates going up in 2011, may be a good idea.

Example: Dave converts his $100,000 traditional IRA to a Roth IRA in 2010

►$50,000 is added to his income in 2011►$50,000 in 2012

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Conversions in 2010

If Dave makes a $20,000 Roth withdrawal in 2011:►Inclusion of distribution is accelerated►Instead of $50,000 being included in 2011 income, $70,000 is

included►Remaining $30,000 is included as income in 2012

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Conversions in 2010

If Dave dies in 2011,►Any remaining amounts become includable in 2011.►However, if his surviving spouse acquires the entire IRA,

she can continue the ratable inclusion.►Election is irrevocable after return due date for year of

Dave’s death.

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Nondeductible contributions (basis) are converted income tax-free

Partial conversions are permitted, but basis amounts convert ratably based on all IRAs

Example: John has 2 traditional IRAs holding $50,000 each. IRA A holds $20,000 in nondeductible contributions, IRA B has none. He converts $20,000 of IRA A to a Roth.

Result: $4,000 of converted amount is basis, $16,000 is includable as income

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Roth IRA Recharacterizations

Recharacterizations: undoing a Roth conversion: ►if converted early in year, then market losses result in reduced

account value,►if income is too high at year-end (2009)

Timing: generally, by due date of income tax return for year of conversion plus extensions (i.e., October 15 of following year)

If return is already filed, taxpayer may amend

Accomplished by means of trustee-to-trustee transfer

Reconversion not permitted until longer of the following tax year or 30 days after recharacterization

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Roth IRA Recharacterizations

Recharacterization strategies: Example

Jeff has $1 million IRA, holds investments in a variety of asset classes

Divides IRA into ten $100,000 accounts in early 2010, each holding specific asset class

Jeff has until recharacterization deadline of October 15, 2011 to see which assets go up, which go down

Jeff keeps those that performed well, recharacterizes those that performed poorly

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Roth IRA Distributions

All Roth IRAs are treated as one for determining tax treatment of distributions

Qualified distributions: general rule – no income tax, no penalty:

(1) Any Roth account of owner that has existed for at least 5years, AND

(2) Owner: Has reached 59½ Has become disabled, died, OR Is first-time homebuyer ($10,000 limit; includes child, grandchild,

ancestor who has not owned a home in 2 years)

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Ordering Rules for Roth IRAs

Distributions come out in the following order:1. Contributed amounts2. Conversion amounts, in the order conversions made (FIFO) Within a conversion amount, first from the portion, if any, that was

includable in gross income as a result of the conversion3. Earnings

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Treatment of contribution amounts:

Return of contributions is always received income tax-free whether 5 years old or not.

No 10% penalty when withdrawn.

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Treatment of conversion amounts:

Received income tax-free (because already taxed) but …

Withdrawal of conversion amounts that were includible as a result of the conversion is subject to 10% penalty if the Roth account to which distribution is allocated is not 5 years old (even if it is not subject to income tax)

5-year period begins with year of conversion

Why? Otherwise, IRA owners could make Roth conversions, then take withdrawals to avoid 10% penalty.

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Treatment of earnings:

Received income tax-free only if “qualified distribution”

If not qualified, included as gross income and potentially subject to 10% penalty

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Roth IRA Distributions: Example

Cliff, age 54, has 2 Roth IRAs

Roth IRA A has existed for 7 years and contains $35,000 of contributions and $8,000 of earnings

Roth IRA B was converted to a Roth at the end of 2008 and contains $400,000, of which $10,000 is earnings

Cliff takes a distribution of $40,000, $20,000 from each account, to buy a new car. Assume no other withdrawals in earlier years.

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The $40,000 withdrawn is treated as follows:

Both IRAs added together for purposes of ordering rules.

$35,000 is considered to come from contributed amounts. This amount is not includable as income and has no 10% penalty.

$5,000 is considered to come from converted amounts. Since it was already taxed, it is not included as income again, but it is subject to the 10% penalty because the conversion IRA has not yet existed for 5 years.

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Operation of five-year rule:

Begins on the first day of the earlier of the taxable year in which the first contribution is made or a conversion is made

Only one 5-year requirement for contribution amounts, but separate 5-year requirement for each conversion amount.

Determined separately for Roth 401(k) accounts.

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Bob, age 48, had an IRA worth $125,000 in early 2008, but that was worth $80,000 by late in the year. He converted it to a Roth on December 1, 2008. IRA contained $20,000 in nondeductible contributions

Bob included $60,000 in gross income in 2008

Note that the conversion of the other $20,000 is accomplished income tax-free

Assume Bob also made a $5,000 Roth contribution in 2008 and that he has no other Roth IRAs.

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Bob takes a distribution in 2009 of $8,000. No additional contribution was made in 2009.

$5,000 is considered to have come from contributions

$3,000 is considered to have come from conversion amounts that were included in income as a result of the conversion

In other words, withdrawals of conversion amounts come first from the part you paid income tax on, not from the part you converted tax-free.

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The $3,000 treated as coming from a conversion amount is not subject to income tax because it has already been taxed

However, it is subject to the 10% penalty because it is withdrawn before the 5-year period has elapsed

The 5-year period began January 1, 2008 and endsDecember 31, 2012

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2009 Opportunities

Upper income taxpayers: objective of “capturing” 35% rate

Roth 401(k) participant can roll over account funds (based on eligibility under plan provisions) to a newly established Roth IRA; no income limit

May be able to harvest losses, identify favorable tax conditions, take other steps to reduce AGI

RMD moratorium for 2009 may allow reduction of taxable income levels

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Does a Conversion Make Sense?

Not for everyone

Not purely a mathematical analysis

Tax rate differential is the most critical consideration, but not the only one

Opportunity for wealth transfer advantages may trump immediate cost factors

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Direct Savings Factors

Ability to pay income tax at today’s rates rather than a rate anticipated to be higher in the future

Opportunity for income tax-free growth, particularly when asset values are depressed

Presence of tax-favorable conditions, such as a credit carry-forward, NOL, harvesting of other losses, large charitable contribution

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Indirect Savings Factors

Tax diversification: being able to take taxable distributions in years when favorable, nontaxable distributions if rates are up or tax deductions have been shifted to another year

More ability to control effect of taxable income levels on Social Security taxation, phase-out of deductions, etc.

Potential to avoid lifetime RMDs; increased wealth transfer

Psychological value of knowing income from account istax-free

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When Is Conversion Less Favorable?

When owner expects to be in a lower marginal tax bracket in the future

When income tax must be paid from the converted assets

When owner is likely to need assets within a few years►opportunity for growth reduced if the investment horizon is

shorter►advantage of not being required to take RMDs is irrelevant if

distributions are needed

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When Is Conversion Neutral?

When income tax must be paid from the IRA assets

AND

The income tax rate remains the same when the conversion is made and when distributions ultimately occur

Even so, other factors may favor conversion

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When Is Conversion Favorable?

When other assets are available to pay the income tax, so that the entire account value can grow income tax-free

When the investment horizon is longer

When the investor anticipates a future increase in his/her marginal income tax rate, or knows the rate will not go down

When asset values are depressed and future growth is expected

When converting helps support estate planning objectives

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Example: Elizabeth is 62 and recently widowed. Her taxable income for 2009 will be about $80,000. Her deceased husband left a $50,000 IRA of which she is named as beneficiary, some life insurance proceeds, and a survivor pension.

In 2009, Elizabeth may file married filing jointly, as a surviving spouse. In 2010, her filing status will be single.

Elizabeth wants to know whether it makes sense to convert the IRA to a Roth. She has life insurance proceeds available to pay the tax.

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Above 372,950

372,950208,850

137,05067,900

16,70010 15 25 28 33 35

2009 Income Tax Brackets forMarried Individuals Filing Jointly

Based on her $80,000 taxable income in 2009, Elizabeth’s 25% bracket has “room” for $57,050 of additional income before she reaches the 28% bracket.


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If Elizabeth made the same conversion as a single taxpayer, she would pay tax at a rate of 28% on the conversion.

Above 372,950

372,950171,550

82,25033,950

8,35010 15 25 28 33 35

2009 Income Tax Brackets forSingle Individuals

When is Conversion Favorable?

When funding a special needs trust with IRA benefits►Conversion to a Roth IRA by a surviving spouse after the first

death can take advantage of “married filing jointly” tax brackets►Surviving spouse with a dependent child (as special needs child

is likely to be regardless of age) has “married filing jointly” brackets for two additional years

►Special needs trust is typically an accumulation trust; trusts are subject to compressed tax rates on income

►Significant tax savings may result if Roth IRA payout can go into the trust on an income tax-free basis

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Wealth Transfer Objectives

No lifetime RMDs required from Roth IRAs; allows full account value to grow potentially income tax-free

Long-term, tax-free treatment combined with “stretch” election provides significant payout to child or grandchild over a lifetime

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Wealth Transfer Objectives

Use of Roth IRA to fund bypass or GST trust more favorable than use of traditional IRA

Paying income tax during lifetime reduces the taxable estate

If income tax on conversion is $100,000 and inside a taxable estate, the net cost of conversion is reduced to $55,000 if 45% of the income tax amount would have been subject to estate tax

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Strategic Role of Life Insurance

Life insurance can provide:

Income tax-free* funding to make a conversion at the first death

Replacement asset for “older” heirs where younger heirs are provided a “stretch” payout

Liquidity to pay any estate taxes due on retirement assets

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After Death of Owner

RMDs required from Roth IRAs after death in same manner as any other IRA

Since Roth IRA owner has no lifetime required beginning date, death is always considered “before the required beginning date”

►This means that if failure to have “designated beneficiary” payout is under 5-year rule

►Important to satisfy requirements for “designated beneficiary” status

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Designated beneficiary status►Individuals directly named by the decedent►Individual beneficiaries of trusts if special requirements met►No designated beneficiaries if a charity or estate is named as of

September 30 of year after year of death

Note that after-death planning deadlines still apply in 2009 even if no distribution is required

Special attention needed when an accumulation trust is named as beneficiary, such as for a beneficiary with special needs

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Five-year period for “aging” of Roth account continues, does not start over

►Example: owner dies after owning account for 3 years, beneficiary must own for 2 more years for all distributions to be income tax-free

►If account is already five years old, all after-death distributions are income tax-free

Distributions until end of fifth year treated under ordering rules described above:

►First as contributions, to the extent thereof►Next as conversion amounts, FIFO►Last as earnings

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Surviving spouse options►Convert traditional to Roth and leave as inherited IRA►Convert traditional to Roth and treat it as spouse’s own IRA►If already a Roth, leave as inherited or treat as own►If traditional, leave as inherited or treat as own

Note that treating an IRA as the spouse’s own means distributions before age 59½ may be subject to 10% penalty.

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Example: Fred dies at age 62, Wilma, age 57, is named as beneficiary of his traditional IRA.

Wilma converts the IRA to a Roth in her own name in the year of Fred’s death.

Following year, Wilma makes a withdrawal. No contributions have been made.

Withdrawal treated as coming from converted amounts; during first 5 years subject to 10% penalty, even though not subject to income tax.

Younger surviving spouses who may need funds should keep some in inherited IRA.

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Nonspouse designated beneficiaries:

If funds coming from a qualified plan, may convert the funds directly to a Roth inherited IRA

If funds coming from a traditional or Roth IRA, may have account retitled in name of decedent for benefit of beneficiary

Note that nonspouse beneficiary of IRA may not convertto a Roth, but nonspouse beneficiary of a qualified plan may do so.

Distributions must begin by December 31 of year after year of death in order to establish a lifetime payout election.

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FAQs

What impact does a Roth conversion have on the taxation of Social Security and on Medicare Part B premiums?

In year of conversion, increases adjusted gross income, making it more likely Social Security benefits will be taxed

Medicare Part B premium may be higher; for 2010 conversion, affects premium in 2012

However, tax-free income in future years reduces AGI and provides flexibility for keeping AGI lower when doing so supports other planning

Ability to avoid RMDs can also make planning more flexible

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FAQs

Is it possible to do a Roth conversion if a 72(t) payout from the IRA is in progress?

Yes; the conversion is not treated as a distribution for purposes of determining whether a modification has occurred.

Distributions subsequent to the conversion will be treated as nonqualified distributions until the requirements for qualified distribution are met.

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FAQs

How much is includable as income if the IRA being converted is an individual retirement annuity or holds an annuity contract as an account asset?

Fair market value of annuity contract on date of conversion is the amount includable as income

To extent annuity is surrendered, amount includable is limited to the actual proceeds (surrendered cash value)

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FAQs

What are the asset protection implications of having funds in a Roth 401(k) versus a Roth IRA?

Roth 401(k) is protected from claims of creditors under ERISA and is shielded in bankruptcy

In nonbankruptcy context, IRA protections vary by state

In bankruptcy context, IRA protected (up to $1 million plus amounts rolled over from qualified plans) under federal bankruptcy law

Note that inherited IRAs not likely to be provided same protections. Naming a properly designed trust as beneficiary may improve protections for beneficiaries.

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FAQs

Can losses in a Roth IRA be deducted or netted against gains in other IRAs?

Only when all amounts in all Roth IRAs have been distributed and total distributions are less than total contributions

Loss is claimed as a miscellaneous itemized deduction

No authority exists for netting Roth losses against traditional gains

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Wealth Transfer Case Study

Ken, IRA owner is 70, wife, Barbie, age 64, is named as beneficiary of his IRA. Ken and Barbie have one daughter, Tara, and one grandson, John, age 10.

IRA value is $500,000

Ken reached age 70½ in 2009. No required minimum distributions are due in 2009

Ken’s first distribution is due by 12/31/10

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Distributions During Owner’s Life

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* Note that no minimum distribution is required fromIRAs for 2009.

Basic IRA Stretch Strategy

IRA owner takes only the minimum distribution annually, names spouse as beneficiary

After death of owner, spouse treats the IRA as his/her own, names younger beneficiary

At second death, younger “designated beneficiary” elects lifetime payout by 12/31 of year after death

►Remember that a charity or the decedent’s estate is never a designated beneficiary

►If beneficiary is taking through a trust, special requirements and documentation deadline must be met

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Example: Ken and Barbie

Ken dies at age 72, account value is $537,252 (5% growth less RMDs); Barbie is 66

Barbie elects to treat the IRA as her own, does not begin distributions until the year she reaches age 70½

Barbie is now the owner of the IRA, names grandson John, now age 12, as beneficiary

Barbie lives to age 75, receives distributions for six years (including year of death)

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Distributions During Barbie’s Life



At Barbie's death, grandson John, now age 22, is beneficiary. John elects to take distributions over his lifetime (starting by 12/31 of year after death)

Income tax deferral is now extended across John's life expectancy of 61.1 years

John's distributions will total $4,632,565 (assuming 5% growth annually)

After taxes, John nets about $3,011,167 over his lifetime (assuming 35% rate)

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Liquidity provided by life insurance can allow family to preserve tax-deferred treatment of IRA funds

Life insurance can help provide liquidity to cover estate taxes

What if John’s lifetime payout could be nearly doubled and income tax-free?

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Roth Conversion Strategy

Barbie received IRA valued at $537,252 at Ken’s death (assuming no 2009 distribution, subsequent RMDs made, and 5% growth)

Assume Barbie meets Roth conversion requirements:►income below $100,000 if 2009, no limit in 2010 and later years►not married filing separately (N/A after 2009)

Assume Barbie converts to a Roth IRA, pays income tax in year of conversion (or over 2011-2012 if converted in 2010 and does not opt out)

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Income tax paid from life insurance proceeds acquired for that purpose

No RMDs are required from the Roth IRA during Barbie’s lifetime; she can leave the IRA undisturbed until it goes to John

Barbie does not lose control over the IRA

IRA funds accumulate for remainder of Barbie's life

Distributions to John after Barbie's death are tax-free if account is 5 years old or more

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Trust as Beneficiary

Barbie makes the Roth IRA payable to a trust for the benefitof John

Trust provisions can require payment of RMDs after Barbie's death over John's life expectancy; prevent John from “raiding” the IRA

Trustee could be required to make distributions at specified dates annually over John’s life, such as his birthday and at Christmas

Total of tax-free required distributions over John's lifetime? $5,845,300

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Life insurance on Ken's life provides Barbie the liquidity needed to convert the IRA and avoid using the funds

Ken's unneeded RMDs* could be used to help pay premiums:►$19,123 age 71►$20,038 age 72

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What About …

Tara? (Ken and Barbie's daughter); was she expecting to receive the $500,000 IRA?

Life insurance on Barbie or survivorship policy on Ken and Barbie can help equalize estate, allow Roth IRA to be passed on to John

IRA could be payable to Tara and John, but payout would be much lower due to reduced amount of tax-free accumulation because of RMDs going to both Tara and John. Also, if account is not split into separate accounts, John’s payout would be based on Tara’s shorter life expectancy.

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Leaving a Legacy: Recap

Ken and Barbie started with $500,000 IRA and unneeded RMDs, created a $5.8 million legacy

No additional market risk has been taken in the IRA

Barbie retained control of the IRA during her lifetime

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Leaving a Legacy: Recap

John (or other grandchildren) are provided a source of income for life that may be income tax-free

Life insurance can provide funds at first death to allow conversion to take place and to equalize the estate with older heirs

Life insurance can provide funds at second death to offer liquidity in the event of estate or inheritance taxes

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Questions?

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