Roth IRA Conversion 2012: Are You a Good Candidate?

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Good Candidate

A tax tsunami is coming at the end of this year. And this is the absolutely last chance for a massive Roth conversion. Two years ago the Bush tax cuts were extended for two years. But the snooze button is running out, and this time the likelihood of another extension is slim. You have just 10 more months to do a Roth conversion under these lower tax rates and move your money to where it will never be taxed again.

Regardless of your political persuasion, Congress agreeing to keep taxes low while we are experiencing the highest debt and deficit in our country’s history is implausible. The best we can hope for is gridlock, which would mean the tax rates expire and return to their previously higher values. And while the classes are paying the highest share of their tax revenues in history, the masses are collecting an even higher share of government expenditures and subsidies. Higher taxes are in our future until we get spending under control.

The government gave you a tax write-off when you put money into your individual retirement account (IRA). Now the government can and will be changing the tax rate you have to pay when you withdraw the money. And when you turn 70 1/2, the government requires you to take at least the required minimum distribution (RMD) each year to force you to pay that tax.

It is as though your IRA has a mortgage on it and next year the government will be raising the rate you will have to pay. A Roth conversion is like paying off the mortgage on your IRA early at these lower rates in order to own your IRA free and clear.

Executing a Roth conversion requires professional assistance. We recommend using this technique as part of a comprehensive financial plan. You will need the guidance of a personal fee-only financial planner and a certified public accountant. Each step could save you a significant percentage of your income or net worth.

The first important decision is deciding if you are a good candidate for a Roth conversion. The answer is yes for most families. A Roth account has several tax advantages over the traditional IRA account. The growth within a Roth account is not subject to tax. Roths waive the annual RMD requirement. Roth distributions are tax free during your lifetime. Roth accounts inherited by your beneficiaries are tax free over their lifetimes.

You may be a good candidate for a Roth conversion in 2012 if you can answer “yes” to any of these statements:

1. You expect your tax bill to stay the same or be higher in the future. The level of your income doesn’t matter. If your income is low, you can convert a portion of your IRA at a low tax rate. And if your income is high, your tax bracket in the future is liable to be higher than it is now as the Bush tax cuts expire.

If you are working throughout 2012 and then turning 65 and retiring in 2013, you might be better to delay your conversion until you have no income and can convert it all in the lower tax brackets. Delay doing a Roth conversion any time you know your taxable income will be lower in future years.

2. You have an IRA that could be converted. The larger it is, the more essential it is to do a Roth conversion. Because the IRS will force you to start taking RMDs at age 70, those distributions could push you into a higher tax bracket. Converting some of your IRA to a Roth will reduce the value of your IRA and lower the distributions you ultimately will have to take.

If you have a 401(k) from a previous employer, you can roll it into an IRA and then convert the IRA. But if you only have your 401(k) from your current employer, in-service withdrawals will probably not be allowed.

3. You have sufficient assets to pay the tax from your nonretirement accounts. You lose many of the benefits of a Roth conversion if you withhold taxes from your IRA account rather than paying the tax from your taxable assets. Having sizable taxable savings allows you to be able to take advantage of tax planning. This is one reason we recommend putting 5% of your take-home pay toward taxable investments.

4. You would like to reduce the value of your gross estate and leave a tax-free asset to your heirs. Converting your IRA to a Roth and then leaving it to grandchildren could produce an after-tax benefit twice as large as leaving them the traditional IRA and the taxable amount that could have been used to pay the conversion tax.

5. You are willing to pay estimated taxes and incur increased tax preparation fees. The conversion slightly complicates your tax preparation, which is why we recommend you engage competent financial advice.

You can reverse a Roth conversion as late as October 15 of the following year. So the more time you allow yourself between February 2012 and October 15, 2013, the more time you will have to determine if the funds you converted to a Roth did well. If your Roth conversion incurred a substantial drop in value, you may want to “recharacterize” and undo the Roth conversion. But if the funds held their value or grew, you will want to keep the Roth conversion.

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.

4 Responses

  1. Steve Wightman
    |

    Item #4 doesn’t make sense to me.
    4. You would like to reduce the value of your gross estate and leave a tax-free asset to your heirs. Converting your IRA to a Roth and then leaving it to grandchildren could produce an after-tax benefit twice as large as leaving them the traditional IRA and the taxable amount that could have been used to pay the conversion tax.

    I understand that paying IRS will immediately reduce the estate value by equal dollars. With an individual estate tax exclusion of $5M each currently, that won’t be a problem for most anyone but the ultra wealthy.

    I question that a Roth will provide twice the benefit of a traditional taxable IRA considering the expectancy of grandchildren and the strech IRA benefits of spreading RMD tax over many more decades than the decedents. Consider too that conversion taxes may trigger AMT, phase out and a push to a higher tax bracket. A better idea is to do small conversions yearly in small bites that do not trigger these consequences and use NOLs and other losses like capital gains losses, to defer the bite of the taxman. I for one, prefer to defer RMD to grandchildren and let them have 50 years to complain about it. At least they’ll remember me! Author of Rocket Roth, 6 Paths to 7 Figures available on Kindle by June 1.

    • David John Marotta
      |

      Greetings Steve,

      The article says you may be a good candidate for a Roth conversion in 2012 if you can answer “yes” to ANY of these questions. #4 is “You WOULD like to reduce the value of your gross estate and you WOULD like to leave a tax-free asset to your heirs.” You then suggested that some people would NOT want to do these, and in those cases a Roth isn’t as justified. Exactly.

      But that concedes the point that if your estate is over $5M (or planning on being over $1M when the estate tax laws are scheduled to revert in 2013) then you WOULD like to reduce your gross estate. We have many clients who are over the $5M and nearly every client over the $1M.

      Similarly, we have many clients whose children are in higher tax brackets than they are. Paying the tax in the parent’s tax bracket is less expensive than paying the Roth RMDs in the children’s brackets many of whom are in the top tax bracket. Clearly if you answered “yes” to “You would like to leave a tax-free asset to your heirs.” than you should do a Roth conversion now, while the tax rates are still low.

      Study after study suggests that leaving a Roth to children or grandchildren often produces more family wealth than leaving them a large IRA and deferring the taxes to 50 years of complaints.

      • Chris Forsyth
        |

        Did you misspeak in using the term “Roth RMD” in this answer? The article states that one of the advantages of a Roth IRA is the absence of RMD’s.

  2. Chris Forsyth
    |

    Now that the year end “fiscal cliff” settlement has concluded with the permanent extension of the Bush tax rates for most taxpayers, does this change your advice? Does it still make sense to convert a traditional IRA into a Roth if my tax rate isn’t changing?

    More broadly, doesn’t the tax benefit of the Roth conversion happen when the current period tax rate is lower than the tax rate at which the IRA distributions will happen? For a taxpayer in the 35% bracket now, doesn’t it seem likely they may be in a lower tax bracket once they retire in ten or twenty years, should they not leave the money in the traditional IRA to be taxed at a lower rate in the future? (I realize the answer requires some unanswerable assumptions about future tax rates, so let’s assume they don’t change, or are indexed to inflation.)

    Thanks!