Additionally, President Obama’s Affordable Care Act (ACA) tax increases take effect
in 2013. This includes a 3.8% Medicare tax on the lesser of net
investment income (dividends, interest, rental income, capital gains,
passive income) or the excess of modified adjusted gross income (MAGI)
over $250,000 (married filing jointly) or $200,000 (single filers). The
ACA also includes a 0.9% increase in the employee’s portion of the
Hospital Insurance Tax on total wages in excess of the $250,000
threshold for married filers and $200,000 threshold for single filers.
If you are close to either threshold, or seeking a way to accelerate
taxable events into 2012 (while tax rates are lower), now may be the
time to convert your traditional IRA into a Roth.
What’s the difference?
In both a traditional IRA and a Roth IRA, your money grows tax free
while in the account. The main difference between the two is when you
must pay taxes on the money put into the account.
With a traditional IRA, you pay no taxes on the funds you put in.
Consequently, you are taxed when you withdraw money from the account.
With a Roth, you are taxed when you put money in, but there is no tax on
funds withdrawn from the account. Generally, Roth IRAs also offer a
little more flexibility if you need to take money out earlier than
Generally, it is advantageous to defer tax liabilities for as long as
possible, but considering the possible increases slated for 2013 now may
be a good time to accelerate taxable events.
Taking a traditional IRA funded with pre-tax dollars and
converting into a Roth triggers a taxable event. If you wait and convert
in 2013, it will affect the determination of whether the Medicare tax
applies to the IRA owner’s investment income. The converted IRA amount
itself is not subject to the 3.8% tax as investment income. However, it
is included in compiling the taxpayer’s MAGI. Therefore, depending on
your circumstances, a Roth conversion in 2013 could increase the IRA
owner’s MAGI over the specified $200,000/$250,000 thresholds, resulting
in the application of the Medicare tax.
Converting now avoids this possibility. Further, assuming individual
income tax rates rise, completing a Roth conversion before year-end
could lock in lower tax rates on the converted amount, avoiding higher
income taxes in the future.
Wait and see?
With so much uncertainty surrounding impending year-end tax changes, it is tough to plan. Why not just take the wait and see approach? We believe it is generally better to take a proactive approach to tax planning. If things change, you can effectively undo the conversion.
You can convert a traditional IRA to a Roth with the understanding that
tax laws permit you to change your mind and retroactively reconvert the
Roth back to a traditional IRA at any time prior the deadline for filing
your income tax return (including extensions) for the year when
conversion took place. This enables you to take action now and revise
your plans later depending on what happens with the Bush tax cuts.
Advantages of a Roth IRA
The advantages and benefits of a Roth IRA over a traditional IRA may
vary depending on your specific circumstances, but generally Roth IRAs
offer the following:
provided the distribution occurs at least five years after you (or your
spouse) first fund the Roth and you reach the age of 59-and-a-half (or
become disabled or pass away); or distribution is for a qualified,
first-time, home purchase.
• Roth IRAs can also maximize tax-deferred growth by deferring required
minimum distributions (RMDs). Unlike traditional IRAs, Roths do not
have RMDs for the original owner or a spouse-beneficiary — so the Roth
IRA assets can grow, untouched and income-tax free, during your
lifetimes. Children or grandchildren who inherit Roths must take RMDs,
but they can extend the distributions over the course of their life
expectancies. This permits smaller distributions and greater assets to
compound within the Roth, income-tax free.
• A conversion to a Roth removes the double income and estate tax hit
on inherited IRAs. When the Roth passes to your designated heirs, an
estate tax applies. However, Roth beneficiaries take their withdrawals
Cost benefit analysis
Obviously, any planning must be predicated upon your particular
situation. Typically, the biggest cost of an IRA conversion is the
acceleration of the taxable event, and the lost opportunity to earn
income on the amount of tax paid.
As discussed above, tax deferral is usually the best approach — but
given the current environment, accelerating recognition of income prior
to the scheduled rate increases may be more beneficial. Also, to
maximize the benefits derived from an IRA conversion, you should attempt
to pay the tax with funds outside of the account.
To determine if a Roth conversion is best for you, consider the typical
benefits against potential lost opportunity cost. Primary factors that
generally determine whether conversion is advisable include:
The longer you can leave funds in a Roth, the greater the advantage.
Conversion is less advantageous if you believe you will need the funds
during your lifetime.
• Applicable tax rates to distributions made to you and/or your beneficiaries if the IRA remains a traditional IRA
If you anticipate lower tax rates in the future when you intend to
begin withdrawals, compared to the time of conversion — then the overall
benefit of conversion will be less.
• Earnings rates generated by the account investments
Lower earnings rates make conversion less advantageous.
• Use of funds for tax payments
If you will need to use account funds to pay the tax resulting from the
conversion, it will lessen the overall benefits of the conversion.
These are general considerations only. The only way to review the
potential advantages of a Roth conversion is to consult your advisor.
Reviewing your financial plan is the only way to see if a conversion
makes sense for you.
If you decide to go through with a Roth conversion, make certain you
factor the decision in with your current estate plans. Designating a
trust as the beneficiary of a Roth IRA can provide asset protection for
beneficiaries. Also, you will have to make certain all beneficiary
designation forms are completed accurately.
Whatever happens at the end of 2012, there will be a tax increase in
2013. If you own a traditional IRA and are close to the Medicare
thresholds, it may be advantageous to review whether a Roth conversion
is right for you, and whether effecting the conversion in 2012 could
increase the conversion benefits given the tax changes scheduled for
Carole C. Foos, CPA, is a tax consultant at the financial consulting firm OJM Group, where Jason Wainscott, JD, is the Compliance Office. They can be reached at 877-656-4362 or firstname.lastname@example.org. For
a free consultation to discuss your 2012 taxes and what you can do to
reduce them, call David B. Mandell, JD, MBA, at (877) 656-4362. You can
also call for a free (plus $10 S&H) copy of For Doctors Only: A Guide to Working Less and Building More. If you would like a shorter free E-book download of our “highlights” version, you can download it here.
OJM Group, LLC. (“OJM”) is an SEC registered investment adviser with
its principal place of business in the State of Ohio. OJM and its
representatives are in compliance with the current notice filing and
registration requirements imposed upon registered investment advisers by
those states in which OJM maintains clients. OJM may only transact
business in those states in which it is registered, or qualifies for an
exemption or exclusion from registration requirements. For information
pertaining to the registration status of OJM, please contact OJM or
refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov).
For additional information about OJM, including fees and services,
send for our disclosure brochure as set forth on Form ADV using the
contact information herein. Please read the disclosure statement
carefully before you invest or send money.
This article contains general information that is not suitable for
everyone. The information contained herein should not be construed as
personalized legal or tax advice. There is no guarantee that the views
and opinions expressed in this article will be appropriate for your
particular circumstances. Tax law changes frequently, accordingly
information presented herein is subject to change without notice. You
should seek professional tax and legal advice before implementing any
strategy discussed herein.