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 Amounts contributed to a Roth IRA are taxed when contributed instead of when they are withdrawn.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on the funds transferred into the Roth IRA, and avoid possible higher post-2012 tax rates completely when amounts are withdrawn from the Roth IRA.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?