Take a fresh look at Roth conversions

With tax issue settled, it's time for financial advisers to help clients re-evaluate their plans

Now that we finally know the tax laws for this year, it is time to sit down with clients and re-evaluate their financial and tax plans. Some may be relatively unaffected by the American Taxpayer Relief Act of 2012, while others may require adjustments.

One obvious discussion point is whether Roth conversions make sense.

For some clients, the extension of the Bush-era tax rates makes converting now a better move than had been anticipated. As an example, married clients with income of $250,000 may not have planned to make Roth conversions because of President Barack Obama’s campaign pledge of raising taxes this year for those who make more than $250,000 annually.

Now, however, they can convert up to $200,000 more per year without pushing themselves into a higher tax bracket. Of course, that could result in fewer itemized deductions and personal exemptions, which begin to be phased out for joint filers at $300,000 of adjusted gross income and for single filers at $250,000 of AGI; financial advisers must consider each case in context.

EXTENSION BENEFIT

One benefit of ATRA’s “permanent” extension of the Bush tax cuts for most clients is that stretching out conversions over a number of years may be a better option than in previous years. In the past, clients may have been more inclined to make large conversions to lock in the tax rate at the time.

That becomes less of a concern now. To take advantage of this approach, some clients may even choose to re-characterize 2012 conversions made with the expectation of higher rates this year.

Example: Jim, who is single, had taxable income of $300,000 last year, excluding his Roth conversion and an individual retirement account worth $500,000. He thought that 2013 tax rates probably would be higher for singles with taxable income above $200,000, so he decided to convert his entire IRA to lock in the 35% maximum income rate.

As we know, Jim lucked out. The 2012 rates were extended for single filers with taxable income of less than $400,000.

As a result, he may want to re-characterize a good portion — say, $400,000 — of the IRA conversion over time, putting it back into a regular IRA.

For instance, assuming that his income remains relatively stable, Jim could reconvert $100,000 annually over the next four years without putting himself into the new 39.6% bracket.

Note that he would have to wait more than 30 days to reconvert any funds he converted last year.

SPREADING OUT LIABILITY

Although any appreciation in Jim’s traditional IRA over the next four years ultimately would be taxable, spreading the liability out over a number of years might make the smaller annual tax bills easier to stomach than the single large bill Jim otherwise would have to pay in his 2012 tax return. Plus, though the conversion income could phase out some of Jim’s itemized deductions or personal exemptions, the ordinary rate that he would owe on his conversions would be no higher than what he would have paid last year.

Although ATRA favorably affected many clients’ Roth conversion plans, the act may have made conversions less favorable for others.

Consider a married client with $450,000 a year in taxable income.

Had rates remained the same for everyone (or if the top rate had kicked in at a higher amount — say, the $1 million that had been proposed by some legislators), that client could have made Roth conversions without paying a higher tax rate. Now he or she is in the highest tax bracket.

A GOOD MOVE?

That might limit the benefits of a Roth conversion but doesn’t automatically mean it wouldn’t be a good move. It could still pay to convert and to use funds that otherwise would be exposed to higher taxes under ATRA and the 3.8% surtax on investment income to pay the conversion tax.

In addition, there is no guarantee that Congress won’t come back down the road and raise rates.

Most of the income tax changes made by ATRA, including the rates, are described under the law as “permanent,” but that may not mean much to some, as it essentially means “permanent until Congress changes its mind.” For such clients, a Roth conversion can provide the peace of mind of a future 0% tax rate, even if it means paying some tax at the 39.6% income tax rate now.

Ed Slott (irahelp.com), a certified public accountant, created The IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group.