Recent Developments Create Roth IRA Year-End Conversion Conundrum for U.S. Taxpayers

Thomson Reuters tax analyst explains both incentive and deterrent to making Roth IRA conversions before 2013

“Well-publicized tax breaks often come laden with buried tax traps,” said Bob D. Scharin, a senior tax analyst for Thomson Reuters. “On the other hand, the fine print sometimes adds further luster to tax gems.”

For instance, Scharin points out, Roth IRAs are known for offering a rare opportunity to generate tax-free retirement income, along with greater distribution flexibility than provided by traditional IRAs that merely defer tax. However, depending on a taxpayer’s individual situation, other tax provisions can either improve or offset the Roth IRA advantage.

Rule of Roths. Contributions to Roth IRAs are not deductible. But distributions—including investment earnings—are tax-free if distributed when the taxpayer is at least age 59½ (with limited exceptions) and after a five-calendar-year waiting period. In addition, the distributions are not subject to the age 70½ minimum required distribution rules.

Traditional IRAs generally can be converted to the Roth variety. If funds are converted from a traditional IRA to a Roth IRA, the part of the converted amount allocable to pre-tax contributions and earnings is taxable for the year of conversion. Consequently, if a taxpayer thinks his or her tax rate will increase in future years, making a Roth IRA conversion in 2012 can be a wise tax move. That way, the conversion is taxed at 2012 tax rates, and the individual reaps tax-free income down the road when the income would otherwise be more heavily taxed.

Additional 2012 advantage. Starting in 2013, a 3.8 percent Medicare surtax is scheduled to be imposed on investment income (including interest, dividends, and capital gains) to the extent the individual’s modified adjusted gross income exceeds $250,000 for joint returns and $200,000 for single filers. While the surtax does not apply to income from a Roth IRA conversion, the income from a 2013 Roth conversion could push a taxpayer’s adjusted gross income above the applicable threshold. If that occurs, the Roth conversion could trigger a surtax on the taxpayer’s investment income.

Independent of the Medicare surtax, income tax rates are scheduled to increase in 2013, even for those of modest income levels. If you do not expect Congress to extend the more favorable rates through 2013, this provides another incentive to have the income from the Roth IRA conversion taxed in 2012.

Look before leaping. Before making a 2012 Roth IRA conversion, taxpayers should consider whether income from the conversion will push them into a higher income tax bracket in 2012—wiping out the anticipated tax savings.

Furthermore, many individuals made Roth IRA conversions in 2010. The added incentives for doing so that year were twofold. First, the income limitation on conversions was eliminated, so those with modified adjusted gross incomes above $100,000 were finally able to make a Roth IRA conversion. Second, the tax law allowed the income from 2010 conversions to be deferred to 2011 and 2012. “If a taxpayer took advantage of this option in 2010, now the second half of the income from the Roth IRA conversion must be reported on the 2012 return,” said Scharin.

A taxpayer who is thinking about making another Roth IRA conversion before 2013 should consider how piling the conversion income for 2012 on top of the deferred income from a 2010 conversion will affect his or her 2012 tax bill. It may easily elevate the individual into a higher tax bracket. It can also cause phaseout of other tax breaks that are subject to income limitations, such as tax credits for college costs.

“With the right timing and individual circumstances, a Roth IRA conversion can create long-term tax savings. For some taxpayers, 2012 is the time to act—and that means implementing plans before year-end. For others, however, waiting until 2013 is a better tax strategy,” said Scharin.

Taxpayers should consult with a personal tax advisor before applying these or other tax strategies.

Up-to-date analyses of legislation and regulations affecting individual taxpayers are available on the industry-leading, award-winning Thomson Reuters Checkpoint research platform.

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