By Guest Author: Robert C. Lickwar, CPA, MST
In recent years, we have enjoyed a variety of strategies for advantageously converting traditional IRAs into Roth IRAs. With tax rates now steeply on the rise on a number of fronts, many taxpayers may think that the conversion boat has already sailed. But before we abandon ship, let’s cover the remaining ways a Roth conversion may still serve taxpayers well, depending on their circumstances.
Roth Conversions: That Was Then, This Is Now
In some respects, 2010 represented the high-water mark for Roth IRA conversions, at least for the foreseeable future. In that year, taxpayers could elect to spread the conversion income over two tax years, 2011 and 2012, making it a particularly attractive opportunity.
Moreover, 2012 appears to be the last year of lower personal income tax rates, at least for a while. Beginning in 2013, single taxpayers with taxable income in excess of $400,000 face a 39.6% rate on the excess. This same rate applies to married couples with taxable income in excess of $450,000. Throw in an increased capital gain and qualified dividend tax rate of 20% for these high-income taxpayers, the 3.8% Net Investment Income Tax (NIIT), and the phase-out of itemized deductions and personal exemptions, and some taxpayers face effective tax rates of 45% or more.
Remaining Benefits for Roth IRAs
These are tall tax hurdles to leap when considering converting a traditional IRA to a Roth. But that doesn’t mean that we shouldn’t still consider – or more appropriately, not forget – the benefits of a Roth IRA:
- Tax-free distributions for qualified distributions.
- Potential elimination or minimization of the NIIT in retirement years. (While, remarkably, IRA distributions are not directly subject to this tax, they do increase Adjusted Gross Income, so they could indirectly incur NIIT payments.)
- The ability for a “re-do.” (Imagine you decide to convert in 2013, but by October 15, 2014, the value of your account has fallen. You can re-convert back to a traditional IRA to avoid the conversion tax you would otherwise pay.)
- Elimination of Required Minimum Distributions during your lifetime, which can help with tax management as well as estate planning goals.
Theory is one thing. Practical application is another. Here are a couple of illustrations to demonstrate the possibilities.
Scenario One: The Brown Family
Paul and Ann Brown are married with two children. Paul is an executive and Ann oversees the household. They have built a nice nest egg, including the children’s college costs via qualified tuition plans and other savings vehicles.
Then, in early 2013, Paul’s firm downsizes, and he is laid off. While Paul searches for his next position, he is serving as a part-time consultant, with projected income of $60,000 for 2013. Traditionally, Paul has earned income that places the Browns well in excess of the highest tax rate. He expects to do so again once he is fully back in the game.
In this scenario, the Browns might do well to convert from a traditional to a Roth IRA in 2013, while they are in a lower tax bracket than usual for them, so they can minimize the conversion taxes owed. For example, if Paul has $250,000 in his former employer’s 401(k) plan, he could roll this amount to his Roth IRA. Converting the entire balance results in an approximate $70,000 IRS tax bill. This would be an effective tax rate of 28%, compared with $100,000 if distributions commenced from the IRA when Paul retires (assuming the maximum individual tax rate remains approximately 40%). In addition, ongoing growth within the Roth IRA is tax-free, unless of course the tax laws change.
This scenario assumes the Browns have funds outside of their IRAs to pay the tax. This provides for maximum tax-free growth opportunities during Paul’s and Ann’s lifetimes, as well as maximum income-tax-free inheritance for their children.
Scenario Two: Sally Green
Sally Green owns a successful small business operating as an S Corporation or an LLC Taxed as a Partnership for Federal Tax purposes. 2013 has been a rough year, however, with the loss of a major customer. Sally projects that the business will lose $300,000, which she can use in a couple of different ways: She could carry it back to recoup some taxes from 2011–2012, or she could convert her $250,000 traditional IRA to a Roth IRA.
Assume that Sally also decides to fulfill her philanthropic goals by establishing a charitable remainder trust. The contribution of appreciated securities is large, and her Adjusted Gross Income is insufficient to absorb the entire contribution deduction due to IRS limits. We can in essence use the conversion of the traditional to a Roth IRA to generate what otherwise may be lost charitable contribution deductions.
There are some other variables to consider here, such as Sally’s projected income in 2014 and beyond, and her projected tax bracket in retirement. The key is, a Roth conversion is one more planning idea we have available to us. It should not be routinely overlooked.
Parting Thoughts on Roth Conversions
When a Roth conversion can be of benefit to your tax planning, we recommend making the conversion in “buckets.” For example, the traditional IRA can be sliced into more than one Roth IRA each holding a particular asset class, such as U.S. small-cap value, REITs or emerging markets. That way, if one asset class rises while another declines, you and your planning professional can undo the conversion for the unsuccessful bucket, while locking in the conversion of asset classes that increased in value.
We also emphasize that the scenarios described will not apply to all taxpayers; not even to most, really. But sometimes it will, and continuing to be on the look-out for these opportunities to convert a traditional IRA to a Roth IRA can still be a valuable planning tool, even in times of rising tax rates.
About Robert C. Lickwar, CPA, MST – Bob is a partner at Del Conte, Hyde, Annello & Schuch, P.C. (DHAS), a certified public accounting and business advisor firm established in 1988. Bob has 24 years of experience as a practicing CPA, and has worked exclusively with privately held businesses and owners to provide compliance services and sophisticated tax planning strategies. He has assisted the firm’s clients in the development of tax-favored and other retirement plans, and has worked with the firm’s partners in developing tax efficient succession transitions, including acquisitions and sales of businesses. He also has extensive experience in dealing with tax authorities at both the federal and state levels.
SAGE Serendipity from Sheri: #GivingTuesday is a campaign to create a national day of giving at the start of the annual holiday season. It celebrates and encourages charitable activities that support nonprofit organizations. In this spirit, I invite you to watch the documentary “Life According to Sam.” I watched it last night and it moved me immeasurably. If you are so moved to help Sam and other children like him, please consider donating to the Progeria Research Foundation. If there is another charity that has special meaning to you, please email us the details and we will include a link to your charity in next week’s SAGE Serendipity.
Sheri Iannetta Cupo, CFP®, is Founding Principal of SAGE Advisory Group, based in Morristown, NJ, an independent, Fee-Only Registered Investment Advisory firm, specializing in providing busy professionals and their families with holistic financial life planning and investment management services. You can find more here: www.sageadvisorygroup.com where this post originally appeared. You can also connect with Sheri on Twitter, Google+ and LinkedIn.