Revisiting Roth Conversions

TCI

Oct 4, 2012

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.

Factors to Consider When Evaluating the Roth Conversion Strategy

While the Roth conversion strategy may be a good idea for you, there are several variables to consider before deciding to go forward. For instance, you should factor in:

  • Expectations about future rates of return on your Roth IRA investments;
  • Expectations about future tax rates;
  • Expectations about whether — and when — you might need to withdraw money to pay for retirement; and
  • Where you will get the cash to pay the conversion tax bill.

This is not necessarily a complete list of factors. Talk with your adviser about the Roth conversion opportunity, but don’t wait until the last minute in 2012 to have the conversation.

Don’t Forget the 2012 Impact of 2010 Conversions

If you did a Roth conversion back in 2010 and chose to spread the resulting extra taxable income 50/50 over your 2011 and 2012 tax years (as allowed under the law), you already have some conversion income that must be reported on your 2012 return.

Therefore, if you do another conversion this year, you will have two layers of extra income to report on this year’s return (from the 2010 conversion and from this year’s conversion). Don’t forget to take both layers into account when estimating the extra tax bill that would result from a 2012 conversion.

Consult with your tax adviser for help with running the numbers.

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:

  • Today’s federal income tax rates are relatively low because the “Bush tax cuts” will remain in effect through December 31, 2012. However the tax cuts expire at year end, and rates will automatically increase for 2013 and beyond unless a new law is passed to extend them.

    So if you convert before year end, you are assured of paying today’s relatively low rates on the extra income triggered by the conversion and you will completely avoid the risk of higher future tax rates on all post-conversion income that piles up in your new Roth account. That’s because qualified Roth withdrawals are totally federal-income-tax-free. (In general, you can take qualified withdrawals after you’ve had at least one Roth IRA open for over five years and reached age 59 1/2.)

  • If you convert this year, you don’t have to worry about the extra income from converting causing you to be hit with the new 3.8 percent Medicare surtax on investment income, which will take effect  next year. While the extra income from a conversion next year would not itself count as investment income for purposes of the 3.8 percent surtax, it would raise next year’s modified adjusted gross income (MAGI). Higher 2013 MAGI could, in turn, cause some or all of next year’s investment income to be hit with the surtax, especially if you convert a traditional IRA with a big balance.

    In other words, while not everyone who converts in 2013 will be exposed to the surtax, nobody who converts this year will be exposed.)

  • Roth IRAs are exempt from the required minimum distribution rules that require you to start taking withdrawals from traditional IRAs after you reach age 70 1/2 or pay a stiff penalty. So you can leave your Roth balance untouched for as long as you live and continue earning federal-income-tax-free money for as long as you live.

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.

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