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February 2017

When clients should open or convert to a Roth IRA

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When clients should open or convert to a Roth IRA

Posted by: Ted on Jul 14, 2016 in News | No Comments
By David M. Barral, CPA/PFS
July 1, 2016

Roth IRA accounts are frequently recommended by advisers but sometimes in what seems a cookie-cutter fashion, assuming everyone should open a Roth account and that everyone with a traditional IRA should convert it to a Roth at any time. In fact, however, whether a Roth is better for the client depends on multiple factors. This article addresses when and why a Roth account makes good sense, as well as best practices in the Roth conversion process. Using a Roth conversion most advantageously could generate a sizable after-tax return.

Roth IRA accounts are frequently touted for their tax benefits, primarily qualified distributions that are tax-free (Sec. 408A(d)(1)). Qualified distributions under Sec. 408A(d)(2)(A) are those paid or distributed after the five-year period beginning with the first tax year for which the individual (or spouse) first contributed to the Roth account established for that individual and are made either:

On or after the taxpayer attains age 59½;
To a beneficiary or the taxpayer’s estate on or after the taxpayer’s death;
On account of the taxpayer’s disability; or
For a first-time home purchase (up to $10,000).
Whether a Roth account makes sense depends on the taxpayer’s current tax rate compared with his or her expected tax rate in retirement, when distributions will generally be made. The CPA can discuss tax rates with the client, along with the types and sources of income the client has now and anticipates later. Obviously, a big unknown is what future statutory tax rates will be. One could argue that, historically, tax rates are lower than in the past, and, therefore, they likely will only go up. However, one also has to consider that the higher rates were in effect before passive activity loss or at-risk rules were enacted and that no one knows what future rates will be.

Generally, if a client’s tax rate is expected to be much higher in his or her retirement years, a Roth account can provide value. The distributions will already have been taxed when initially contributed or converted to the Roth account. Unfortunately, however, the taxpayer may view the analysis as a cash flow issue. The Roth will provide no current tax benefit via a deferral of current income tax on contributions. If an individual anticipates being in a significantly higher tax bracket later in life, then it would be best to forgo a current-year tax deduction, such as that provided by a pretax retirement account contribution (e.g., to a Sec. 401(k) account or a traditional IRA) and to make Roth contributions or a conversion.

Therefore, Roth accounts cannot be recommended across the board; every client’s needs and resources must be analyzed. Most financial planning scenarios anticipate that individuals will live in retirement on perhaps 70% to 80% of their preretirement income and will have a lower tax rate. For them, a Roth account might not make sense.

Other factors include the type of income received or expected in retirement, such as qualified dividends or tax-exempt interest. In addition, Roth IRAs are not subject to required minimum distributions (RMDs), so these accounts can grow far into retirement. Note, however, that designated Roth accounts (“Roth 401(k)s”) are subject to RMDs; therefore, a Roth 401(k) should be rolled over into a Roth IRA to avoid the RMD rules.

Time-value-of-money concepts can help reinforce with clients the need to analyze Roth account planning.

Example: Assume a 30-year-old has no retirement plan currently at work, so a traditional IRA contribution can provide an adjustment to arrive at adjusted gross income (AGI) in calculating his tax liability. He saves $100 every month and wants to put a year’s worth of these savings ($1,200) into either a Roth account or a traditional IRA, along with the current-year tax savings he will realize from making a contribution to a traditional IRA. The taxpayer will not make any distributions from the account he contributes to for 30 years, and it will earn 5% annually. Table 1 compares the future value of the investment in a traditional IRA versus a Roth account where the taxpayer has a constant tax rate throughout the entire period of investment and retirement of 30%.

Table 1: A constant 30% tab rate at contribution and distribution

Table 1 shows that with all things remaining equal, including current and future tax rates, it makes no difference in which type of account the taxpayer’s retirement contribution resides; both the Roth account and the traditional IRA have the same future value.

Next, in Table 2, assume the same conditions as in Table 1, but with a current tax rate of 30% and a tax rate in retirement of 40%.

Table 2: A current tax rate of 30% and future tax rate of 40%

Table 2 shows that with a higher tax rate during retirement, the taxpayer comes out ahead with a Roth account. Next, Table 3 shows the reverse, with a current tax rate of 40% and a tax rate in retirement of 30%, resulting in a higher future value for a traditional IRA.

Table 3: A current tax rate of 40% and future tax rate of 30%

Comparing a traditional and a Roth IRA can suggest another consideration when a taxpayer wants to contribute the maximum amount into a traditional IRA or a Roth account. For 2015 and 2016, the maximum contribution is $5,500 (or, for an employer plan, 100% of compensation includible in gross income, if less) or $6,500 for taxpayers age 50 and older. The tax benefit from the IRA deduction can be invested in an ancillary taxable investment account. Here, the tax benefit cannot be included in the IRA account (growing tax-deferred) because the maximum annual contribution was made. With a 30% tax rate, an extra $2,357 would be invested in a separate, taxable account ($5,500 ÷ (1 − 0.30) = $7,857; $7857 − $5,500 = $2,357).

This aspect of a Roth analysis may only apply to Roth IRAs vs. traditional IRAs and not to Roth 401(k)s vs. traditional 401(k)s. This is because the IRA can provide a tax benefit in the form of an above-the-line adjustment in determining AGI, which may help provide a refund for the taxpayer, which in turn may yield a cash lump sum (tax refund) to invest, while the 401(k) tax benefit would be realized in each paycheck in an amount that would have to be set aside for investment. In either case, this strategy is often burdensome and usually not cost-effective for the CPA and the investment adviser to plan and analyze. This additional investment strategy also requires considering the investments chosen and taxes due on the investment results.

Amounts in a traditional IRA may be converted into a Roth IRA by a trustee-to-trustee transfer, by a transfer to a Roth account maintained by the same trustee, or by a rollover contribution within 60 days of a distribution. The portion of the distribution or transfer that is not treated as a return of after-tax contributions to the traditional IRA is added to gross income in the year of the conversion and thus is subject to income tax but not the 10% additional tax under Sec. 72(t).

Roth conversions often seek to take advantage of the taxpayer’s current (lower) tax rate and market conditions affecting the account’s value. In addition, Roth accounts are intended for use in retirement and should be given time to grow and allow interest and appreciation to compound. Conversions done too close to retirement may not provide much value. Clients converting to a Roth also need to consider how to pay the additional taxes due.

One example of when a Roth conversion works well and can provide a substantial tax benefit is when the taxpayer starts a new business and anticipates losses or substantially lower income, which may result in little or no tax liability on the conversion.

Sometimes the taxpayer may be reluctant to go through with the conversion because of a dismal economic outlook. To pay tax on the fair market value of the account and later have the account value decline will only leave the taxpayer regretful. To help protect the taxpayer from this unfavorable result, the CPA could advise setting up separate Roth IRA accounts for each investment category or sector and converting separate amounts into their own respective accounts, thus allowing a taxpayer to take maximum advantage of his or her ability to recharacterize IRA contributions (including conversion contributions).

Taxpayers are permitted to recharacterize IRA contributions, that is, change their nature to or from Roth or traditional (Sec. 408A(d)(6) and Regs. Sec. 1.408A-5, Q-1). If the client implements the strategy described in the preceding paragraph and a Roth account in a particular investment sector does not perform well, the taxpayer can recharacterize the contribution to that account back to a traditional IRA account. A rollover from an employer-sponsored retirement plan to a Roth IRA cannot be recharacterized back to the employer’s account; it would have to be transferred to a new or existing traditional IRA.

Recharacterizations can be done as late as the extended due date for the return for the year the contribution was made (Sec. 408A(d)(7)). For example, a taxpayer who made a Roth conversion for 2015 in January 2015 could recharacterize it as late as Oct. 15, 2016 (assuming he or she has timely filed a return, i.e., filed a return by the unextended due date or filed an extension and filed a return by the extended due date). Clients who have filed timely 2015 returns before recharacterizing a conversion may recharacterize the conversion by Oct. 15, 2016, if they file an amended return for the year (on or before the due date for amended returns). For many investors, 2015 did not provide much of a return, and there may indeed be some regrets for 2015 conversions.

A taxpayer may reconvert contributions recharacterized from a Roth to a traditional IRA back to a Roth IRA again. However, the taxpayer must wait until the later of (1) 30 days after the recharacterization or (2) the beginning of the tax year following the first Roth conversion (Regs. Sec. 1.408A-5, Q-9).

Thus, Roth accounts can provide value and flexibility for the client, but only if they are established and maintained in the most advantageous way. With the right tools and approach, CPA advisers can analyze clients’ circumstances, needs, and resources to fashion a retirement plan that may, if indicated, make use of a Roth IRA, either through regular contributions or a conversion.

Worker Classification and the Evolving Service Delivery Model

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Worker Classification and the Evolving Service Delivery Model

Posted by: Ted on Jul 14, 2016 in News | No Comments
By Kathy Mort, CPA, Pittsburgh, and Megan Marlin, J.D., LL.M., Washington
July 1, 2016

Editor: Annette B. Smith, CPA

Determining whether a worker is properly classified for tax purposes as an independent contractor or an employee is complex. The fact-intensive nature of this inquiry is complicated because the criteria and methodologies used by the IRS to assess a relationship between the service provider and the service recipient often differ from those used by other federal or state government agencies, including the U.S. Department of Labor (DOL) and the National Labor Relations Board (NLRB).

For federal employment tax purposes, this issue generally relates directly to a business’s liability for payroll taxes: federal income tax withholding; Social Security and Medicare (together, Federal Insurance Contributions Act (FICA)); and Federal Unemployment Tax Act taxes. However, worker classification has a broader, significant impact. It affects a worker’s entitlement to pension, health, and welfare benefits; the applicability of minimum wage and overtime provisions; and a worker’s ability to claim unemployment, workers’ compensation, and disability coverage.

Further, since enactment of the Patient Protection and Affordable Care Act (PPACA), P.L. 111-148, there have been concerns over the impact that worker misclassification may have on an employer’s potential liability under Sec. 4980H. That section generally provides that applicable large employers, i.e., those with at least 50 full-time employees, are subject to an excise tax if at least one full-time employee is certified as having enrolled in a qualified health plan for which a premium tax credit or cost-sharing reduction is allowed or paid (i.e., via a health care insurance exchange). As a result, employers that already face substantial exposure for employment tax liabilities also may be subject to significant excise tax assessments under PPACA for misclassification.

Common Law Standard

Congress adopted the common law standard in defining “employee” for FICA purposes in 1948 (Sec. 3121(d)(2)), rejecting an economic-reality test (see S. Rep’t No. 1255, 80th Cong., 2d Sess. 3-4 (1948)). Under common law, the treatment of a worker as an independent contractor or as an employee originates from the legal definitions developed in the law of agency—whether one party, the principal, is legally responsible for the acts or omissions of another party, the agent. Following the common law standard, the employment tax regulations provide that an employer-employee relationship exists when the party for whom the services are performed has the right to direct and control the worker who performs the services. This control refers to direction over the result to be accomplished as well as how that result is accomplished.

In the context of an IRS examination, employment tax specialists probe the relationship between the service provider and the service recipient to ascertain the degree of control. The IRS approach to analyzing classification of workers has changed infrequently over the years. Historically, when determining worker status, examiners have referred to 20 factors identified in court decisions and published in Rev. Rul. 87-41. In 1996, the IRS revised its training program for agents, suggesting that their audit approach should take into account changes in the workplace and the corresponding changes in the relevancy and emphasis of factors that are most persuasive. The methodology adopted in those materials is still used today.

Agents evaluate three categories of evidence: behavioral control, financial control, and the relationship of the parties. Behavioral controlfocuses on facts that illustrate whether there is a right to direct or control how the worker performs the specific task for which he or she is engaged, such as instructions and training. Financial control focuses on facts that illustrate whether there is a right to direct or control how the business aspects of the worker’s activities are conducted, such as whether the worker makes a significant investment,has unreimbursed expenses,whetherservices are available to the relevant market,the method of payment,and the opportunity for profit or loss. In assessing the relationship of the parties, agents focus on facts that illustrate how the parties perceive their relationship, such as intent of the parties expressed in contracts, employee benefits, terms of discharge or termination, and the regular business activity.

The IRS continues to emphasize publicly that it intends to pursue worker misclassification in employment tax examinations and has made numerous announcements about its combined efforts with states and the DOL to curb misclassification. At the same time, IRS enforcement is limited by certain restrictions.

Section 530 Relief

Section 530 of the Revenue Act of 1978, P.L. 95-600, is a relief provision for employers that unintentionally misclassify employees. Perhaps most notably, if Section 530 applies, a business may continue to treat workers as independent contractors, and the IRS cannot retroactively classify certain individuals as employees. A lesser-known provision of Section 530 provides that, except with respect to certain technical service workers, the IRS is barred from issuing regulations or revenue rulings pertaining to worker classification (Revenue Act of 1978 §530(b)). As a result, the IRS cannot issue new revenue rulings or even modify existing revenue rulings to reflect new developments.


Legislators have regularly introduced bills to address worker misclassification. For example, the Fair Playing Field Act of 2015, S. 2252, would require the IRS to offer guidance on the distinctions between employees and nonemployees, end the moratorium on the IRS’s prospectively reclassifying workers, retain the Section 530 safe harbor, and require employers to notify independent contractors of their tax obligations. The Payroll Fraud Prevention Act of 2015, H.R. 3427, would make changes to the Fair Labor Standards Act and impose additional employer reporting requirements and new penalties for misclassification, similar to the Employee Misclassification Prevention Act, S. 3254, which was introduced in 2010. While it seems unlikely that bills on worker classification will be enacted this year, these and other legislative initiatives highlight ongoing concerns from a policy perspective about worker misclassification.

Changing Environment

Many commenters recently have called for recognition of a new, third worker category, in addition to employees and independent contractors, to reflect the increased growth in on-demand worker platforms. The common law has been the standard for analyzing worker classification for nearly 80 years, and the most recent IRS guidance that agents use to apply that standard is 20 years old. The passage of time has not eased the difficulty or decreased the number of ongoing disputes regarding worker classification. In fact, complexities inherent to the issue seem to be magnified as the business and technology environments change the relationships between service providers and businesses.

Forbes reported in late 2014 that an estimated 53 million Americans—approximately 34% of the total workforce—were freelancers, and that number was expected to increase to 50% by 2020 (see Wald, “5 Predictions for the Freelance Economy in 2015,” (Nov. 24, 2014)). The freelance workforce also is evolving as increasingly sophisticated systems enable businesses to respond to the market’s desire for nontraditional work arrangements. The freelance workforce, often referred to as the “gig economy,” is expanding rapidly because internet platforms can be used to connect service providers and service recipients to provide service on demand. The gig economy generally includes industries in which workers complete tasks on an on-demand or client-by-client, as-needed basis, such as drivers and technicians, grocery or restaurant delivery services, and marketing. The emerging gig economy again has raised questions about how to classify workers for tax purposes.

The traditional factors used to assess worker classification do not translate easily to modern platforms that connect parties who want to provide services with those who request services. In every relationship where services are provided, of course, there is some degree of control by the service recipient and some degree of autonomy on the part of the service provider. In gig economy arrangements, factors that can point to contractor status, depending on a full analysis of all facts and circumstances in each situation, include that the freelancers may be able to set their own work schedules and have a right to decline work. They may be subject to little to no oversight or evaluation when they perform services and may be in a position to negotiate their pay.

Other factors may indicate an employment relationship, such as that freelancers often have little control over the method and means of payment and client choice, may not hold themselves out as being “in the business,” may have little investment in materials and tools, or do not advertise their services. While there has been litigation in several states on these issues under state law, it remains to be seen how these relationships will be viewed by the IRS and whether these emerging economic relationships may trigger a fresh look at how workers generally are classified (see O’Connor v. Uber Technologies, Inc., No.4:2013cv03826 (N.D. Cal. 8/16/13) (complaint filed), and Silver v. Unemployment Compensation Bd. of Rev.,34 A.3d 893 (Pa. Commw. Ct. 2011)).

Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.

For additional information about these items, contact Ms. Smith at 202-414-1048 or

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.

How much do you really know about Roth IRAs?

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How much do you really know about Roth IRAs?

Posted by: Ted on Feb 26, 2016 in News | No Comments
Having been a tax practitioner and financial advisor for quite a while now, I am still scratching my head, trying to understand what the allure is of this investment vehicle. I’m still drawing a blank.

I often receive questions about investing in these tax-sheltered vehicles but more often than not I receive information at tax time when the client has already made the decision to make the investment.

From a tax perspective this is important because in most cases people are making contributions that they are not allowed to make based on the IRS limitations for both traditional and Roth IRAs. An unqualified contribution can be reclassified and subject to a 6% excise tax.

But that’s just compliance. Why do I think they’re inappropriate and inefficient investments? Let’s first start with why the Roth was created. To find the answer you have to understand what the motivation is for congress to offer this type of product to the public through large institutional banks and brokerage firms. It should come as no surprise to you that congress has been growing our deficit for decades, meaning tax revenues are not keeping up with tax expenditures (offering tax sheltered investments as an example) and to cover the gap it has to print money.

This has been the case since the economic meltdown in 2008. Through the governments intervention to save banks that are too big to fail we now have the Federal Reserve artificially keeping rates low so banks are able to recapitalize their balance sheets and recover from near collapse. The Federal Reserve is also making sure rates are low because as the deficit keeps growing the interest on the increasing obligation continues to grow as well, deepening the already large crater in the US deficit.

Contrary to popular opinion that the government always operates for the common good of the people, in this case, the government chose a financial strategy to slow down the expenditures on tax sheltered vehicles like a traditional IRAs and deployed the new Roth IRA so that it does not give up anymore tax revenue.

In effect, the government is trying to dissuade you from making tax deductible contributions that would benefit you today but do not benefit the government. Now we’re seeing new products offering corporate Roth IRAs that allow you to contribute to the Roth IRA versus a 401k giving the government the relief it needs while penalizing you for saving and making you feel you’re doing something right.

The only entities Roth IRAs help are the government and large financial institutions packaging new products to peddle to you. The government doesn’t lose any revenue on your contribution to a Roth and large investment institutions continue to market these vehicles as sound retirement alternatives. They know your hands are tied until you reach age 59 ½. What a wonderful continuous revenue stream for both while exposing you to unknown market risk for decades.

At the same time while we sacrifice our investment dollars making these contributions year after year we just accept living in perpetual debt while financing the US government and big banks. Does that make sense to you?

From the value perspective, what exactly is so interesting in investing in a Roth IRA? First, and most important, you cannot get a tax break on the contribution! Then you have income limitations and if you don’t qualify but still make incorrect contributions you can be subject to a 6% excise tax. Third, you cannot take your money out in an IRA until you’re 59 ½ without paying a 10% penalty and in a Roth while you can take out your principal, any profit would be subject to the 10% penalty as well. The so-called big ‘benefit’ in the Roth is that you are not required to take minimum distributions at age 70 ½. So that’s the big benefit? Who the knows if we’ll even be around at that age let alone worry about paying a small amount of tax by taking a distribution at a time when we’ll probably need it anyway before age 70 ½?

So in a nutshell, we’re scrambling to save and entangle our money in government sponsored vehicles that yield us zero benefit today, for the hope that we’ll live to age 70 ½ and be so wealthy that we won’t need to take a distribution out of our IRAs. Doesn’t sound very realistic for most of us.

I’m not even going to get started on your investment limitations and choices depending on your investment provider. Usually you’re stuck with a small amount of funds to choose from or index funds of some sort. Let’s consider what the market has been doing in just the last month. It tanked! And to those of you patiently waiting and sitting on the sidelines in 2015, you were able to buy up so many wonderful companies on an individual basis, at a discount, and continue to dollar cost average – job well done.

So what are you supposed to do? How are you supposed to plan for the future, your retirement and the security of your family? Aren’t there more efficient ways to invest and deploy your money? There are indeed.

I’d be happy to share my thoughts and ideas with you. It starts with setting priorities and realizing your earning potential has limits so you have to be extremely careful with how you deploy your hard earned dollars. Do you trust the government or large financial interests to help you?

For starters, trust in yourself, know your limits, reduce your debt, hedge against inflation (rents) by buying an affordable home, protect your income and family and invest the difference in high quality, important companies that pay dividends.

There are time-tested, proven strategies for building wealth with minimal risk.

Let’s start the conversation.

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