More On Tax Planningfrom The Advisor's Professional Library
- IRAs: Eligibility The eligibility rules for contributing to traditional and Roth IRAs are complicated. Learn how to effectively use them in retirement plans.
- Annuities: Variable Annuities Annuities are hot. The tax rules vary with the circumstances. Advisors must be aware of these intricacies when discussing annuities with clients.
Your clients’ tax rates will almost certainly be rising by the end of the year if the Bush-era tax cuts expire. Despite this, there is an opportunity to avoid some of these tax increases by using Roth conversions. Instead of paying the potentially higher 2013-and-beyond tax rates on IRA funds, clients can roll their traditional IRA accounts into Roth IRAs, paying taxes on those funds at 2012 rates. In 2012, almost all of your clients are good candidates for this solution, but the time to act is now—by the end of the year, the opportunity may be lost, and your clients left wondering why they are stuck paying more.
Back to Basics: Benefits of a Roth Conversion
There can be substantial advantages to executing a Roth conversion in 2012. As previously stated, tax rates are almost certain to rise in 2013, so your clients would be forced to take withdrawals at that higher tax rate. A traditional IRA is subject to minimum distribution requirements once a taxpayer reaches age 70½, so your clients would certainly incur the increased tax liability at that time, if not before.
Although funds in both traditional and Roth IRAs grow tax-free, the traditional IRA grants only a tax deferral because the funds are contributed with pre-tax dollars but are taxed as ordinary income upon withdrawal. Amounts contributed to a Roth IRA are taxed when contributed instead of when they are withdrawn. What this means is that your client could execute a Roth conversion in 2012, pay taxes at the 2012 rates on the funds transferred into the Roth IRA, and avoid possible higher post-2012 tax rates completely when amounts are withdrawn from the Roth IRA.
Further, funds in the Roth IRA are not subject to the same minimum distribution requirements as a traditional IRA, so your clients could see their Roth funds grow tax-exempt for a longer period.
Who Is a Good Candidate?
In 2012, almost everyone is a good candidate for a Roth conversion. As long as your client expects to remain in the same (or higher) tax bracket, the tax savings are likely to be substantial. Despite this, a Roth conversion requires payment of taxes upon conversion, so the client should have sufficient assets to make this payment.
There are, of course, exceptions—for example, taxpayers who plan on dropping to a lower tax bracket in 2013 and beyond should wait to execute a Roth conversion at this lower tax rate. This might be the case if your client is planning to retire in 2013, drop to a lower tax bracket and take distributions at this lower rate.
What Happens If You Guess Wrong?
Sometimes the converted funds will fare poorly after a Roth conversion, or the client may convert too much and end up in a higher tax bracket the next year (though this is unlikely for 2012 Roth conversions because tax rates will most likely be higher in 2013). Because the goal of a Roth conversion is to pay less in taxes during the year that the conversion takes place than would be required for future distributions, an estimate of the future value of the funds is required because this value helps determine the minimum distribution requirements.
After the Roth conversion, if the value of the funds in the account drops to where the tax would be lower even at increased 2013 rates, your client may come to you looking for answers. Fortunately, if the results of a Roth conversion are poor, the transaction can be reversed—“recharacterized”—as late as October 15 of the year following the initial conversion.
For example, if your client wishes to convert a $1 million traditional IRA, he would incur income tax liability on the $1 million at the time that the funds are converted. If the value of the account drops significantly within the period for recharacterization, the client could transfer the funds back into the traditional IRA and reverse the income tax liability incurred on the $1 million. The next year, the client could try again to execute another Roth conversion, paying income taxes only on the reduced amount.
The possibility that tax rates will continue rising for the foreseeable future is very real. Because of this, 2012 is likely the last chance for your clients to take advantage of the relatively low 2012 rates by executing a Roth conversion. At least for 2012, the risks are slight and the rewards potentially great.
See AdvisorOne’s Special Report, 22 Days of Tax Planning Advice for 2012, throughout the month of March.
For additional coverage of this issue and similar ones, we invite you to sign up with AdvisorOne’s Summit Business Media partner, AdvisorFX, for a free trial.