Tax and Money Tip of the Week
Roth IRA Conversions: Opportunities and
Deadlines | September 19th, 2012 | No. 110
Potential increase in federal income tax may make 2012 Roth conversions attractive
When you convert a traditional IRA to a Roth IRA, the conversion is generally taxed as ordinary income (except for any after-tax, nondeductible contributions you’ve made). With the “Bush tax cuts” set to expire at the end of 2012, federal income tax rates will jump up in 2013. Unless Congress acts, we’ll go from six federal tax brackets (10%, 15%, 25%, 28%, 33%, and 35%) to five (15%, 28%, 31%, 36%, and 39.6%). While there continues to be discussion about extending the expiring tax cuts, many believe there’s little chance of resolution until after the November election.
While no one can predict what Congress will ultimately do (or not do), 2012 may present an opportunity to convert a traditional IRA to a Roth IRA at a potentially lower tax cost than if you wait until 2013.
You can convert now, or you can take a wait-and-see approach–you have until December 31 to make a 2012 Roth conversion. Either way, if converting turns out to be the wrong decision, you’ll have until October 15, 2013, to “undo” your conversion, and it will be treated for federal tax purposes as if it never occurred.
Keep in mind that the potential 2013 tax rate increase is just one factor to consider when deciding if and when you should convert a traditional IRA to a Roth IRA. If you’ll need to pay the conversion tax with IRA funds, or if you think you’ll be in a lower tax bracket when you begin taking distributions, a Roth conversion may not be right for you.
You have until October 15, 2012, to undo a 2011 Roth conversion
If you converted a traditional IRA to a Roth IRA in 2011, and your Roth IRA has sustained losses, you may want to consider whether it makes sense to undo (recharacterize) your conversion. You have until October 15, 2012, to undo your 2011 conversion. (If you’ve already filed your federal income tax return for 2011, you’ll need to file an amended return if you recharacterize.) A recharacterization can help you avoid paying income tax on the value of IRA assets that have been lost. When you recharacterize, your conversion is treated for tax purposes as if it never happened.
For example, assume you converted a fully taxable traditional IRA worth $100,000 to a Roth IRA in 2011. However, due to market volatility, that Roth IRA is now worth only $60,000. If you don’t undo the conversion you’ll pay federal (and possibly state) income tax on $100,000, even though the current value of those assets is only $60,000. If you undo the conversion, you’ll be treated for tax purposes as if the conversion never happened, and you’ll wind up with a traditional IRA worth $60,000–and no resulting tax bill.
If you recharacterize your 2011 conversion, you’re allowed to convert those dollars (and any earnings) to a Roth IRA again (“reconvert”) but you’ll have to wait 30 days, starting with the day you transferred the Roth dollars back to a traditional IRA. Keep in mind that even though the amount you recharacterized, and any earnings, is subject to a 30-day waiting period, any other amounts in your traditional IRAs are not subject to the waiting period, and you can convert all or part of those dollars to a Roth IRA at any time.
Whether it makes sense to recharacterize your Roth conversion depends on several factors, including the extent of the losses in your Roth IRA, and your expectations of where the markets may be headed.
Call me to help decide if a recharacterization is right for you.
Questions or Comments?
Mark Vitek, CPA/PFS, CFP®
…until next week.