With tax hikes around the corner, one of the year-end tax moves in millionaires’ playbooks is converting a traditional individual retirement account into a Roth IRA. It’s a way to fight upcoming tax hikes, whether or not we fall off the fiscal cliff. It could make your retirement a lot richer--whether you’re a millionaire or just have an IRA in the five figures.
Here’s a millionaire example, courtesy of Robert Keebler, a CPA in Green Bay, Wisc. and a Roth cheerleader. A 65-year-old farmer client in the 35% federal bracket (the top rate today) put North Dakota farmland in his IRA and hit oil, literally. He just got the land appraised for $1 million, and is converting the IRA to a Roth, paying the give-or-take $350,000 income tax hit out of other assets. “It’s a brilliant strategy,” Keebler gushes. “By doing this, he preserves his 35% income tax rate, and all future distributions will be income tax free.”
That’s the beauty of a Roth. If you anticipate higher taxes, you can lock in today’s rates. If the farmer had done the conversion before he struck oil, it really would have paid off because you pay income tax on the value of the IRA assets when you convert.
2012 Roth Ira conversions are on the list of potential tax strategies of more people than any year except perhaps in 2010, says CPA and lawyer Robert Carlson in his latest Retirement Watch newsletter. Before 2010, you could only do a Roth conversion if your income was $100,000 or less. When that income limit was lifted Jan. 1, 2010, there was a flood of Roth conversions.
Now folks are hustling again to do them by year-end in anticipation of looming tax hikes expected on Jan. 1. For high-income taxpayers (just how high is still being hashed out), the 35% rate could jump to 39.6%. Capital gains and dividends rates may go up too. Also, a new 3.8% surtax on investment income and a new 0.9% surtax on wages and self-employment income are scheduled to kick in for singles earning $200,000 plus and married couples earning $250,000 plus.
Need a rundown on conversion basics? A traditional IRA is usually funded with earned income that hasn’t yet been taxed. Investments grow tax deferred, and withdrawals are taxed at ordinary income rates. A Roth is funded only with after-tax dollars, but any withdrawals made after five years and past age 59 ½ are tax free.
In a conversion, you withdraw funds from a traditional IRA, pay the ordinary taxes due on any pre-tax contributions and tax-deferred investment growth, and then move the cash (or whatever the underlying investment is) into a Roth, where future growth is tax free. Another factor favoring Roths: you don’t have to take the money out when you reach 70 ½ like you do with a traditional IRA.
Not only millionaires need apply for the conversion tax break. Anita Katzen, a CPA in New York City, has a client in her mid-50s who is taking advantage of a down year in her business (she’s 100% owner of a marketing firm) to convert $60,000 of a $240,0000 IRA to a Roth. She’s funding a 401(k) to the maximum with a $22,000 contribution for 2012, so the $60,000 of taxable conversion income keeps her in the 15% bracket. “She’s one of my model clients,” Katzen says. “She’s created a low personal overhead, and she has a lot of savings.” That let her use a bad year to do the Roth conversion at a bargain rate and help cushion future, more profitable, years.
As Katzen’s example shows, a Roth conversion is not an all or nothing proposition. A free online calculator by Convergent Retirement Plan Solutions shows the effect of converting different amounts, say 10% or 50%, of your IRA balances.
Of course, Roth conversions aren’t for everyone, as Keebler points out in Five Reasons Not To Convert To a Roth. The reasons in brief: if you expect to be in a much lower tax bracket in retirement (say by moving from a high-tax state to a low-tax state), you’re nearing retirement and will spend your IRA, you don’t have money outside the IRA to pay the conversion tax, you plan to leave a lot to charity at your death, or if asset protection is important to you.
But the arbitrage between current rates and the higher rates come Jan. 1 "just screams" for at least a partial Roth conversion for most folks, Keebler says. If we're totally wrong and rates don't go up, the Internal Revenue Service allows a do-over called a "recharacterization" where you basically undo the Roth, he notes. You can undo 2012 conversions up until Oct. 15th, 2013 as long as you timely file your 2012 tax return.
Still on the fence? Here are 10 points in favor of a Roth conversion.