Given the recent downturn in the global economy, Bermuda business owners who are also citizens of the United States may be reporting a net operating loss on their 2009 tax returns. Applying the loss in the current tax year or carrying the loss forward can be attractive for certain business owners looking to convert assets presently held in a traditional Individual Retirement Account (IRA) or a solo 401(k) to tax-free Roth IRA retirement assets. For certain taxpayers, the income generated by a Roth IRA conversion could be offset by the net operating loss, and the business owner would not incur any additional tax liability. Thus for the soon to retire solopreneur, there still may be an opportunity to turn current economic challenges into longer-term economic benefits. The following provides some important context to the overall dilemma:

With the Taxpayer Relief Act of 1997, Congress created the Roth IRA as a new alternative to the existing traditional IRA that had been around for nearly 25 years.

Prior to that point, tax-preferenced retirement savings only existed in one variety - the traditional IRA that allowed pre-tax contributions and tax-deferred growth, ultimately taxed as ordinary income but only at the time of withdrawal. With the introduction of the Roth IRA, though, taxpayers suddenly had a second choice - to make contributions with after-tax dollars and give up the tax deduction for contributions, in exchange for the opportunity to receive not only tax-deferred growth, but tax-free withdrawals of that growth for retirement purposes.

Not only were investors presented with a choice about which account to contribute towards, they were also granted the opportunity to make a conversion from the pre-tax traditional IRA into the after-tax Roth IRA.

Beginning in 2010, the income limits for conversions of funds in a traditional IRA to a Roth IRA are removed, allowing anyone to complete a Roth conversion in 2010 and beyond (or at least until the rules are changed again). Previously, only individuals with modified adjusted gross income (MAGI) of $100,000 or less were eligible for conversion. This prohibited many Bermuda residents from qualifying for utilising this investment vehicle. In addition, a one-time rule applicable to 2010 conversions only gives taxpayers the option to report the amount of income from a Roth conversion evenly in 2011 and 2012.

On the surface, the Roth conversion question seems simple enough: Do whatever will result in the lowest amount of income tax on retirement assets. The argument in favour of paying the tax now is that the assets are assumed to grow in the future. By converting to a Roth, all that future appreciation forever escapes income taxation (with certain limitations). The argument against converting now is that you may be in a lower tax bracket at retirement.

To make a decision about whether to convert a traditional IRA to a Roth IRA one must at a minimum forecast an individual's future income tax rates to compare to the current tax rate.

More and more Roth conversion calculators are showing up every day. Unfortunately for consumers, as with any program, the output is only as good as the input. In the case of any program, the input includes the assumptions the program uses to arrive at an answer.

We believe that the decision to convert requires a more client-specific analysis than any of the free calculators can provide. As noted above, the decision making process starts with an assessment of what your future tax situation will look like. This is based in large part on how your lifestyle will be funded in the future and the resulting estimated tax payable.

This will be followed by a calculation of how much the conversion will cost, how this will be recouped and how much better off or not you will be. Most of the calculators we have seen simply offer a simplistic set of assumptions that can provide results that are misleading.

We believe that the question of conversion is not adequately answered by a "yes" or "no". Rather, we believe that the question of conversion raises more specific questions to ensure a thorough evaluation and a comprehensive final conversion strategy.

For example, if after an initial analysis you determine that conversion may be beneficial, the following questions should be answered: 1) are you converting the whole account now or is it more optimal for you to make more than one conversion? 2) How much should be converted at any given time? 3) What is the impact to your current year tax liability due to conversion? Will it move you into a higher tax bracket? What amount of the traditional IRA is taxable on withdrawal? 4) What taxable account will you draw from to pay any resulting tax liability? Do you have losses that can be used?

Overall, the Roth IRA can provide an opportunity to tax events in a manner that allows the taxpayer to pay a tax liability when tax rates are anticipated to be lowest. This opportunity to time the taxation of retirement savings alone can present a significant opportunity to enhance wealth and the longer the time period and greater the growth rate, the more wealth that is accrued via a favorable tax timing decision.

Nonetheless, the Roth IRA is not for all situations and the risk of "over-converting" is real and which could create unnecessarily large current tax liabilities that may actually result in less future wealth. It's a great opportunity for some, but not for all.

Patterson Partners Ltd. specializes in the provision of tax, estate, investment and strategic planning services to dual citizens of the USA and Bermuda, their families and businesses. For more information, visit www.patterson-partners.com or contact Jennifer A. Patterson, CFP®(US), CIMC™, CIMA®, TEP via email at info@patterson-partners.com or phone 296-3528.

Asgill Post Ltd. provides assistance with Business Valuation, Financial Strategy and the Purchase and Sale of Companies. For comments or queries, contact Kumi Bradshaw MBA, CBA, BVAL via email at kumi@asgillpost.com or phone at 295-3301.