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Should you make a Roth IRA conversion in 2012?

February 13, 2012

© 2012 by Michael C. Gray, CPA

With the current uncertainty of the future of the federal income tax system, here are three reasons for considering converting a regular IRA or retirement account balance to a Roth during 2012:

1. Future regular federal income tax rates may go up. The Bush tax cuts are currently scheduled to expire after 2012. The current maximum federal regular income tax rate is 35% and that rate is scheduled to increase to 39.6% after 2012, unless Congress takes action. Most commenters believe Congress will extend the tax cuts beyond 2012, but President Obama is seeking increased rates for individuals with adjusted gross income exceeding $250,000.
   
   (I don’t expect Tax Reform to be resolved until after the 2012 presidential election, possibly not until 2013 or later!)
   
   Especially hard hit would be certain "qualified dividends." The maximum federal tax rate for those dividends is now 15%. Unless Congress takes action, the maximum rate for those dividends will increase to 39.6%!
   
   By converting regular IRA or other retirement account balances to a Roth during 2012, you would pay tax at the lower current rate and totally avoid future federal income taxes for the account.
2. The Medicare tax. An additional 3.8% Medicare tax for investment income, including most taxable long-term capital gains, is scheduled to become effective in 2013. The tax will apply for individuals with modified adjusted gross income exceeding $200,000 for singles, $250,000 for married persons filing joint returns, and $125,000 for married persons filing separate returns.
   
   This tax will not apply to distributions from retirement accounts, but will apply to earnings from reinvested distributions. There are no required distributions for a Roth IRA account during the original owner’s lifetime.
3. Tax-free accumulation of earnings. After a short waiting period, most earnings are income tax-free while accumulated in the account and when distributed. (There is an exception for unrelated business taxable income in the Roth account. It won’t apply to most taxpayers. See your tax advisor for details.) There is a toll to pay, since the Roth conversion is taxable.
   
   Again, by paying the tax for a 2012 conversion, the federal tax may be at a much lower rate than would be paid later for a distribution from an IRA or other retirement account. The higher the tax rates, the bigger the advantage of using a Roth account.
   
   The younger the account owner, the bigger the advantage of this tax-free accumulation. Since an inherited account can be distributed over the beneficiary’s life expectancy, this avoidance can continue for a long time after the original account owner is deceased. The younger the beneficiary, the bigger the advantage, provided the beneficiary doesn’t accelerate distributions.

You can change your mind

If a Roth conversion is made during a taxable year, it can be reversed by a trustee-to-trustee transfer to a regular IRA no later than the extended due date of the federal tax return for the year. The accumulated earnings attributable to the conversion amount are also required to be transferred to the regular IRA account to qualify as a reversal.

Using a conversion to beat Roth contribution limits

For 2012, annual Roth contributions (other than rollovers and conversions) are phased out for "modified adjusted gross income" from $110,000 to $125,000 for singles, $173,000 to $183,000 for married persons filing joint returns, and $0 to $10,000 for married persons filing separate returns.

If you have no IRA accounts for previous years, you can make a $5,000 non-deductible IRA contribution for 2011 up to April 17, 2012. The non-deductible IRA can then be converted to a Roth account. There may be little or no taxable income for income accumulated in the non-deductible IRA after setting it up. Effectively, the Roth contribution limits are defeated in this scenario.

If you already have "regular" IRA accounts accumulated through funding with deductible contributions in prior years and/or with rollovers from qualified plans, such as 401(k) accounts, all of the IRA accounts are treated as one account when a distribution is made. This means a Roth conversion after a non-deductible contribution to a "regular" IRA will carry out taxable income attributable to deductible contributions and rollovers from taxable retirement accounts.

For example, if a regular IRA previously only had tax deductible contributions and had an opening balance of $45,000, and a $5,000 non-deductible contribution was made for 2012, followed by a $5,000 Roth conversion, the taxable income for the conversion would be $4,500. ($5,000 X $45,000 / $50,000.)

Conclusion

Now that regular IRA and retirement accounts can be converted to Roths regardless of the level of income, taxpayers have considerably more flexibility to accumulate more funds in Roth accounts. These transactions should be made under the guidance of a tax advisor who is familiar with the rules together with a financial advisor.

The answer about whether to go ahead with a Roth conversion is one you should develop together with a tax advisor considering your individual situation. (We can help—call 408-918-3162 for an appointment.)

For more information about Roth and traditional IRAs, buy our book: How to use Roth & IRA accounts to provide a secure retirement, 2012 Edition!

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