Salaried

401(k) Roth Conversion: Alternative Minimum Tax Payers Need to Give this Serious Consideration

Saturday, April 16th, 2011 | Print This Post Print This Post | Email This Post Email This Post

Recent tax law changes have opened up a whole new area of tax planning around employee retirement plans.  Individuals with IRA accounts always have had the opportunity to do a Roth conversion, but now for the first time an employee’s 401(k) account also may be converted.  Because a 401(k) typically will have a much larger balance than an IRA, this tax opportunity deserves serious consideration, particularly for individuals who currently are in the Alternative Minimum Tax.

 

Background

 

This past September the Small Business Jobs Act of 2010 was signed into law.  One of the provisions in this act allowed, for the first time, a “regular” 401(k) to be converted to a Roth 401(k).  The sponsoring employer first must make the appropriate plan amendments to allow this, but because of the popularity of this provision it is estimated that over half of all employers already have made this change.

 

What happens upon conversion?

 

The dollars an employee contributes to a regular 401(k) are pre-tax.  What this means is that income taxes have not yet been paid on these contributions; instead, when distributions are taken from the plan, typically at retirement, taxes are paid at that point.  Along with the original contributions, the investment earnings in the 401(k) likewise are taxable when withdrawn.  In contrast, a Roth is funded with after-tax dollars, so, correspondingly, there are no taxes due at the time the funds are withdrawn.  Similarly, the earnings on these funds are not taxed at distribution.

 

At the time of conversion from a regular 401(k) to a Roth, income taxes must be paid on the full amount converted.  With this prepayment of taxes, and the 401(k) now officially a Roth, no taxes are due when distributions are made.

 

Example

 

Assume over the years you have put $100,000 into your regular 401(k), and the cumulative investment earnings are $50,000.  If you did a Roth conversion today, assuming you are in the 33% Federal bracket (Regular Tax; not the AMT), along with a state tax rate of 6%, you would pay $58,500 in taxes, leaving $91,500 for your retirement spending.

 

Compare this to an account that was a Roth 401(k) right from the start.  Since you would have paid the 33% and 6% taxes before the monies went into the account, you would have contributed only $61,000 ($100,000 less $39,000 in taxes).  Earnings on this at the same rate of growth as in the example above would have been $30,500, for a grand total in the account of $91,500.

 

The point

 

As was seen in the example above, there is one single most critical point in making a Roth conversion analysis: the comparison between the taxpayer’s current tax bracket and the tax bracket he or she expects to be in at retirement.  How does one go about making this comparison?

 

Tax brackets – assuming no changes

 

On the IRS web site one can see that, assuming married filing jointly status, the Regular Tax 28% bracket is reached at $83,600 of taxable income, the 33% bracket at $174,400, and the 35% bracket at $379,150.  Compare this to the AMT bracket of 26% for Alternative Minimum Taxable Income up to $175K, and 28% for everything over that level.  Ignoring for purposes of simplicity the fact that taxable income is not computed the same for the AMT as it is for the Regular Tax, looking at these brackets reveals something very interesting: AMT brackets are significantly lower at roughly comparable levels of income.

 

This fact alone is the reason individuals currently in the AMT definitely need to give serious consideration to doing a Roth conversion.  The potential for a 7% savings from differences in the tax brackets (28% vs. 35%, e.g.), or even more, definitely is there.

 

Tax brackets – there will be change

 

Making things a little more difficult, however, is the fact that tax brackets will change.  Someday the Democrats will get their way and the Bush tax cuts will be allowed to expire.  When this happens, Regular Tax rates will increase, and it will appear even more attractive to do a Roth conversion today.  Keep in mind, however, that one of the other likely changes in tax brackets simply will be the individual taxpayer’s level of income.  For most folks, income in retirement will be less than what it is while they are working, and, thus, that person’s tax bracket will decrease.  To what extent this will or will not offset the anticipated increase in the brackets from the law changing is up to each individual to decide.

 

Conclusion

 

The recent change in the tax law allowing Roth conversions presents every individual with a 401(k) a real opportunity to save taxes.  This opportunity is much greater for taxpayers who currently are paying the Alternative Minimum Tax than it is for those who are not.  A little time spent making a Roth conversion analysis easily could result in thousands of dollars in tax savings.

 

 

Posted in AMT Planning in General, Calculation of the AMT, Retiree, Salaried, Type of Taxpayer | No Comments »

Exercising Employee Stock Options – Beware of the Alternative Minimum Tax

Saturday, April 2nd, 2011 | Print This Post Print This Post | Email This Post Email This Post

With the stock market having nearly doubled over the past two years, many individuals holding stock options that they received from their employers are giving serious consideration to cashing out the value in these options.  This article discusses the two principal types of options and explains the different AMT issues associated with each.

 

Types of stock options

 

For tax purposes there are two types of stock options – “qualified” and “nonqualified.”  The official term for a qualified option is Incentive Stock Option, commonly referred to as an “ISO.”  Each employer has the discretion, through the design of its plan, as to which type of option it grants to the employee, and it is not uncommon for some employees to have both types.  It is important to note here that it is the responsibility of the individual to understand what he has.

 

Stock option essentials

 

A stock option, like any other option, is a contract giving one person the right to buy property from another person at a predetermined price.  If the underlying property (stock) increases in value, the value of the option correspondingly increases.  If the value of the stock decreases, the option has no value.  Options generally have a fixed term – five to ten years for stock options is common, so the employee must act within this period or the option will lapse.

 

Example – an employee is granted an option to buy 1,000 shares of his employer’s stock at today’s value of $50.  If the stock increases to $60 before the option lapses, the employee can exercise the option, effectively buying the shares from the employer at a discount and, in this example, realizing a $10,000 gain.  To alleviate the hardship of asking the employee to write a check for the $50,000 exercise price, employers commonly arrange with a broker to allow what is referred to as a “cashless” exercise involving a same day sale.  In this situation, on the date of exercise the broker sells an equivalent number of shares, and then sends the employer the $50,000 along with enough to cover the tax withholding requirements.  Then, at the close of the market’s three-day settlement period, the net amount ($10,000 less taxes) is credited to the employee’s account.

 

Tax results from option exercise

 

Nonqualified option – on the date of exercise the $10,000 in the above example is taxable income.  This is ordinary income, not capital gain, just as if it were part of the employee’s salaries and wages.  The $10,000 will be included in taxable income reported in the employee’s W-2 at the end of the year.

 

ISO (qualified option) – The $10,000 will not be taxed as income on the date of exercise.  Instead, it is a tax preference item for purposes of the AMT, meaning that Alternative Minimum Taxable Income will be higher than the employee’s Regular Tax taxable income by $10,000.  The number in this example is relatively small, but if the preference item from an ISO exercise is large enough the employee easily can find himself stuck in the AMT.  If the individual already is in the AMT, the hit from an ISO exercise will make it just that much more painful.

 

Tax planning for option exercises

 

The exercise of a nonqualified option does not have any direct AMT consequences.  As an individual’s taxable income increases, however, the Alternative Minimum Tax exemption is phased out, so testing for the impact of this is important before exercising even a nonqualified option.

 

Especially critical, however, is tax planning before doing an ISO exercise.  In order to exercise an ISO without triggering the Alternative Minimum Tax, the individual has to do the tax calculation under alternative assumptions as to the size of the exercise, as well as consider doing the exercise partially in one year and partially in the next.  By doing this it certainly is possible to minimize the impact of an ISO exercise.  Note also that the employee has a period of time after the exercise within which a sale of the stock will constitute a “disqualifying disposition,” thus negating the AMT effect and retroactively treating the transaction as if it were instead a nonqualifying option.

 

Summary

 

The underlying investment decision as to the right time to cash out of employee stock options must, of course, must be the individual’s primary focus, but if that exercise will bring along with it a big AMT hit taxes need to be considered in deciding how many options to exercise and in what year they are exercised.  That nice chunk of extra income the employee thinks he is getting can be seriously eroded by improper tax planning.

 

Posted in AMT Exemption, AMT Planning in General, Incentive Stock Options Exercised, Salaried, Type of Taxpayer | No Comments »