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Kick off Roth conversions in 2012

by on
in Small Business Tax,Small Business Tax Deduction Strategies

Unless you’ve been hiding under a rock somewhere, you probably know all about the benefits of converting a traditional IRA to a Roth IRA. But you might not realize that there’s a sense of urgency.

Alert: Income tax rates are going up in 2013. For example, the top 35% tax rate is being replaced by a top rate of 39.6%. What’s more, a new 3.8% Medicare surtax applies to certain high-income taxpayers. Thus, a Roth conversion could effectively be taxed at a combined rate as high as 43.4%.

But you may reduce your tax burden by converting to a Roth in 2012 instead of waiting. And an alternative approach for some taxpayers is to arrange a series of Roth conversions. It doesn’t have to be all-or-nothing.

Here’s the whole story: “Qualified distributions” from a Roth in existence at least five years are completely exempt from federal income tax. Qualified distributions include those made after reaching age 59½, on account of death or disability, or to pay so-called first-time homebuyer expenses (up to a lifetime limit of $10,000). In contrast, distributions from a traditional IRA are taxable at ordinary income rates.

Also, you don’t have to take required minimum distributions (RMDs) from a Roth IRA during your lifetime. With a traditional IRA, you must begin taking RMDs after you reach age 70½.

The trade-off for these benefits is that you have to pay current tax at ordinary income rates on the amount you convert into a Roth IRA. For instance, if your traditional IRA is worth $1 million and you convert the whole shebang, you’ll owe a conversion tax of $350,000 if you’re already in the top 35% tax bracket in 2012.

Even worse, if you wait until next year to convert, the tax on a $1 million conversion could reach as high as $396,000. And when you figure in the new 3.8% Medicare surtax, you’re just adding fuel to the fire. Beginning in 2013, the surtax applies to the lesser of the lesser of net investment income or the amount by which modified adjusted gross income (MAGI) exceeds $250,000 for joint filers or $200,000 for single filers. For this purpose, “net investment income” includes interest, dividends, royalties, rents, gains from dispositions of property (other than sales of an active trade or business) and income from passive activities, but not tax-free interest or distributions from qualified retirement plans and IRAs.

Note that the amount converted to a Roth doesn’t itself count toward net investment income, but it could still raise your MAGI, thereby increasing your exposure to the 3.8% Medicare surtax in the year of a conversion.

Naturally, there are several economic and personal factors to consider before you convert (see box below). However, assuming a conversion makes sense, why wait until next year if you’ll be paying more tax? Also, remember that you can use a series of conversions to move funds from a highly valued IRA.  

One approach: Figure out the amount you should convert each year. Focus on staying within the lower tax brackets without jumping into a higher tax bracket. For example, in 2012 the highest 35% tax bracket begins at $388,350 of taxable income for a joint filer. Suppose you have $200,000 of taxable income. If you convert $188,350 in a traditional IRA this year, the entire conversion is taxed at the 33% rate instead of any portion being taxed at the 35% rate. Plus, you don’t have to worry about the 3.8% Medicare surtax. Go through the same process in succeeding years.

Tip: For other taxpayers, a full conversion in 2012 may be the optimal strategy if you can afford to pay the tax all at once.

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