Revisiting Roth Conversions
|There was a time when 2010 was considered the year of perfect storm conditions for converting traditional IRAs (including SEP-IRAs and SIMPLE-IRAs) into Roth accounts. Previous income restrictions on Roth conversions were removed (even billionaires can convert under the current rules). On top of that, income triggered by conversions was taxed at relatively low rates that are still in effect for the rest of this year.
In 2012, the income restrictions are still removed and relatively low tax rates are still in effect. However, tax rates are scheduled to increase in 2013 unless Congress acts. So in 2012, we may once again be looking at perfect storm conditions for Roth conversions.
Here’s what you need to know to assess the idea of converting before the end of this year.
Roth Conversion Basics
A Roth conversion is treated as a taxable distribution from your traditional IRA, because you’re deemed to receive a taxable payout from your traditional account with the money then going into your new Roth account. So a conversion before year end will trigger a bigger federal income tax bill for this year (and maybe a bigger state income tax bill too).
However, three positive factors may outweigh the extra 2012 tax hit:
Roth Conversion Details
If you have several traditional IRAs, converting doesn’t have to be an all-or-nothing proposition. You can convert some accounts and leave others alone. Similarly, you can convert only a proportion of the balances in one or more traditional IRAs.
If you’ve made some non-deductible traditional IRA contributions over the years, and then convert some of your traditional IRA balances to Roth status, the deemed distribution that takes place when you convert will be partly taxable and partly tax-free. The taxable and tax-free amounts will be based on the combined value of all your traditional IRAs (including any SEP-IRAs or SIMPLE-IRAs) on the conversion date and the combined amount of nondeductible contributions to all those accounts. So the taxable part and the nontaxable part of the deemed distribution will be the same regardless of which account you actually convert.
Example: You have two traditional IRAs worth $50,000 each. The $50,000 balance in IRA No. 1 is solely from deductible contributions and earnings. The $50,000 balance in IRA No. 2 consists of $15,000 of nondeductible contributions and $35,000 of deductible contributions and earnings. If you convert IRA No. 1 to Roth status, the resulting $50,000 deemed distribution will be 15 percent tax-free ($15,000/$100,000 equals .15) and 85 percent taxable ($85,000/$100,000 equals .85). If instead, you convert IRA No. 2, the results will be exactly the same.
Ill-Fated Conversions Can Be Reversed
Another nice thing about the Roth conversion strategy is you are allowed to change your mind well after the fact. Specifically, you have until October 15, 2013 to recharacterize (unwind) a 2012 conversion.
Example: You decide to convert a traditional IRA into Roth account this year. By the middle of 2013, the value of the converted account has plummeted due to poor investment performance. In this bleak scenario, you would have to pay 2012 income tax on value that later disappeared. Bad idea! Thankfully, you have until October 15, 2013 to recharacterize the converted account back to traditional IRA status. After the recharacterization, it’s as if the ill-fated conversion never happened. So you won’t owe any income tax from the 2012 conversion that you later reversed.
Consider Splitting Up Large Accounts Before Converting
If you have a large-balance traditional IRA that you intend to convert into a Roth account this year, consider splitting it up into several smaller traditional IRAs. Then convert them into separate Roth accounts and follow different investment strategies for each one. If one of the new Roth accounts plummets in value next year due to poor investment performance, you can avoid an inflated 2012 conversion tax hit by recharacterizing that account back to traditional IRA status by October 15, 2013 (as explained immediately above). You can leave the better-performing accounts in Roth IRA status.
Today’s Roth Equation
Relatively low current tax cost for converting plus the chance to avoid higher tax rates scheduled for 2013 and beyond on income that will accumulate in your Roth account equals another perfect storm for a Roth conversion strategy in 2012. Nevertheless, consult with your tax adviser before making a conversion move. With the complexity of taxes today, no-brainers are few and far between, and you want to make sure all the relevant variables are considered.