More On Tax Planningfrom The Advisor's Professional Library
- Annuities: Estate Tax The value of certain types of annuities may be included in an estate’s value. Understanding the intricacies of these inclusions is a critically important aspect of estate planning.
- 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.
Many clients who converted traditional IRAs into Roths last year with an eye toward higher taxes in 2013 may now want to unwind those conversions. Because these clients could not predict the exact impact of the conversion until they calculated last year’s taxes, some of these conversions may no longer make financial sense.
If this is the case, you still have time to help your clients undo these Roth conversions and eliminate the corresponding tax liability, but the decision must be made quickly because the Oct. 15 deadline for recharacterizing Roth conversions is fast approaching.
Initial Motivations for Converting to a Roth
The primary factor that motivated conversions to Roth IRAs in recent years has been the prospect of higher ordinary income tax rates in 2013. Funds contributed to a traditional IRA are contributed pre-tax today, but are taxed at ordinary income rates when they are eventually withdrawn. Conversely, funds contributed to a Roth are taxed today and withdrawn tax-free. For clients who expect to stay in the same tax bracket, paying the tax at 2011 or 2012 rates was a smart move because of the anticipated tax hikes in 2013.
Why Recharacterize a Roth Conversion?
Despite the substantial tax benefits that come with Roth IRAs, there are plenty of reasons why a client might want to undo a conversion and transfer funds into a traditional IRA.
If your client’s Roth IRA performed poorly since it was converted, it might not be worth the taxes that the client continues to owe in 2012, even though the value of the account decreased. For example, if a client in the 35% tax bracket converted $100,000 into a Roth IRA in 2011, and the account depreciated in value to $70,000 (albeit quite a drop), the client will owe taxes on the $100,000 that he converted, even though the account is now worth much less. The client would probably want to recharacterize the Roth IRA and move the funds back into a traditional IRA to avoid the tax hit. He can always try again by converting the funds in 2012 (and recharacterize in 2013 if necessary).
A client who has unexpectedly jumped into a higher tax bracket may want to recharacterize a Roth conversion because keeping the conversion means that he must pay the taxes on the account value this year at a higher than anticipated rate. Clients who had unexpected expenses in 2012 and simply cannot afford to make the tax payment today can also recharacterize the funds and defer the tax liability to a later date.
It is important that clients who recharacterize a Roth IRA do so correctly. The client can choose to recharacterize only a portion of the Roth IRA, but the amount recharacterized must be transferred to the traditional IRA in a trustee-to-trustee transfer (meaning that the client cannot receive a check for the funds transferred because they are directly transferred to the IRA custodian).
The client also must file an amended tax return reflecting the recharacterization by the Oct. 15 deadline in order to reverse the tax liability under the conversion.
While converting to a Roth in 2012 remains a smart move for many clients, advisors should examine the results of any conversion because of the uncertainty accompanying that initial conversion. The option of undoing the conversion and trying again for next year is a valuable part of the Roth conversion strategy and could save your clients thousands in taxes.
Please visit another of The National Underwriter Company’s expert authors, Michael Kitces, MSFS, CFP®, CLU, ChFC, at FPA Experience 2012. Michael (also a regular AdvisorOne blogger) will be presenting on “Understanding the New Medicare Taxes” as well as signing copies of his new book,The Advisor’s Guide to Annuities, 3rd edition, published for 2012 by The National Underwriter Company.
For additional coverage of this issue and similar ones, we invite you to sign up with AdvisorOne’s Summit Business Media partner, National Underwriter Advanced Markets, for a free trial.