The pros and cons of Roth IRAs, which were introduced 20 years ago, are well understood. All money...
Is the Timing Right for a Roth Conversion?
The ads urging retirement-savers to convert a traditional IRA to a Roth IRA have largely disappeared. But the main reasons to consider a conversion, outside of a special one-year tax-deferral opportunity, remain valid. Converting in 2012 may still be a good idea. In fact, due to projected tax increases for 2013, there is extra tax incentive to convert to a Roth this year.
Basic premise: With a traditional IRA, all or part of an individual’s contribution may be tax-deductible, based on his or her modified adjusted gross income (MAGI) and whether the individual (or spouse) participates in an employer retirement plan. Distributions, which must begin after reaching age 70½, are taxable at ordinary income rates.
In contrast, contributions to a Roth IRA are never tax-deductible, regardless of the individual’s MAGI and plan participation. But qualified distributions from a Roth IRA in existence at least five years are completely tax-free. For this purpose, “qualified distributions” include those made after reaching age 59½ or made on account of death or disability. Furthermore, lifetime distributions are not required after age 70½.
If an individual converts a traditional IRA to a Roth, he or she owes income tax on the portion of the conversion representing deductible contributions plus taxable earnings. Only the portion representing nondeductible contributions is exempt from tax. The tax is based on a pro rata share of all of the individual’s IRAs. In other words, tax cannot be reduced simply by converting an IRA used solely for nondeductible contributions.
For conversions occurring in 2010, an individual could choose to have the conversion taxed over the following two years—2011 and 2012—instead of paying all the tax up-front. This tax election is no longer available. Nevertheless, an IRA owner may still choose to convert to a Roth due to the attraction of tax-free payouts in the future. Another reason to convert is that the owner can preserve a larger share of the IRA assets for future generations without having to take mandatory lifetime distributions.
Currently, the highest tax rate an individual may pay on a Roth IRA conversion is 35%. However, tax rates are set to increase in 2013, barring any new legislation from Congress. The two top tax rates are scheduled to rise to 36% and 39.6%, respectively. In addition, beginning in 2013 a special 3.8% Medicare surtax may apply to net investment income in 2013, raising a high-income-earner’s effective tax rate even higher. These tax-rate increases might encourage a conversion in 2012.
Roth IRA conversions often make sense for individuals who are retired or nearing retirement, but every situation is different. Also, be aware that a Roth may be “recharacterized” back into a traditional IRA, within certain time limits, if circumstances dictate. Please contact our office if we need to work through this decision with you.