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Is It Still a Good Idea to Convert a Roth IRA?

November 19, 2012

Possibly, if you make the conversion before the end of 2012, Read why.

Previous income restrictions on Roth conversions have been removed, even for billionaires. On top of that, income triggered by conversions taxed at relatively low rates are still in effect for the rest of this year.

However, tax rates are scheduled to increase in 2013 unless Congress acts. That’s why some tax advisors say 2012 represents 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. This means 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.

What if You Have Converter’s Remorse? 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.

Today’s Roth Equation with 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, please contact any member of our tax services group before making a conversion move. With the complexity of taxes today you want to make sure all relevant variables are considered.

KLR’s tax professionals are CPAs and attorneys who have specialized training and experience in the Boston market place in all matters of Federal, State and Local Tax Issues. They have expertise in tax strategies for individuals and families, estate gift & trust services, voluntary disclosure issues, transfer pricing, M&A assistance, cost segregation studies and research & development tax credits. KLR is one of the top 100 accounting firms in the nation.

Read more timely tax information on the KLR Tax Blog.

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