Many experts claimed that 2010 was the year of perfect storm conditions for converting Traditional, SEP, and SIMPLE IRAs into Roth IRAs. Not only were previous restrictions removed, but income created from conversions was taxed at a relatively low rate.
The year of perfect storm conditions is in effect until the end of 2012 when tax rates are scheduled to increase in the New Year. So, before tax rates rise and Roth conversions become a bit nonsensical due to the tax burden, read on to learn everything you need to know about Roth Conversions and if it makes sense for you to do before the end of 2012.
The following information is from an article by Bizactions.com called, “It’s Still a Good Time for Roth IRA Conversions.”
“Roth Conversion Basics
A Roth conversion is treated as a taxable distribution from your traditional IRA, because you’re deemed to receive a taxable payout from your traditional account with the money then going into your new Roth account. So a conversion before year end will trigger a bigger federal income tax bill for this year (and maybe a bigger state income tax bill too).
However, three positive factors may outweigh the extra 2012 tax hit:
• Today’s federal income tax rates are relatively low because the “Bush tax cuts” will remain in effect through December 31, 2012. However the tax cuts expire at year end, and rates will automatically increase for 2013 and beyond unless a new law is passed to extend them. So if you convert before year end, you are assured of paying today’s relatively low rates on the extra income triggered by the conversion and you will completely avoid the risk of higher future tax rates on all post-conversion income that piles up in your new Roth account. That’s because qualified Roth withdrawals are totally federal-income-tax-free. (In general, you can take qualified withdrawals after you’ve had at least one Roth IRA open for over five years and reached age 59 1/2.)
• If you convert this year, you don’t have to worry about the extra income from converting causing you to be hit with the new 3.8 percent Medicare surtax on investment income, which will take effect next year. While the extra income from a conversion next year would not itself count as investment income for purposes of the 3.8 percent surtax, it would raise next year’s modified adjusted gross income (MAGI). Higher 2013 MAGI could, in turn, cause some or all of next year’s investment income to be hit with the surtax, especially if you convert a traditional IRA with a big balance. In other words, while not everyone who converts in 2013 will be exposed to the surtax, nobody who converts this year will be exposed.
• Roth IRAs are exempt from the required minimum distribution rules that require you to start taking withdrawals from traditional IRAs after you reach age 70 1/2 or pay a stiff penalty. So you can leave your Roth balance untouched for as long as you live and continue earning federal-income-tax-free money for as long as you live.
Roth Conversion Details
If you have several traditional IRAs, converting doesn’t have to be an all-or-nothing proposition. You can convert some accounts and leave others alone. Similarly, you can convert only a proportion of the balances in one or more traditional IRAs.
If you’ve made some non-deductible traditional IRA contributions over the years, and then convert some of your traditional IRA balances to Roth status, the deemed distribution that takes place when you convert will be partly taxable and partly tax-free. The taxable and tax-free amounts will be based on the combined value of all your traditional IRAs (including any SEP-IRAs or SIMPLE-IRAs) on the conversion date and the combined amount of nondeductible contributions to all those accounts. So the taxable part and the nontaxable part of the deemed distribution will be the same regardless of which account you actually convert.
Ill-Fated Conversions Can Be Reversed
Another nice thing about the Roth conversion strategy is you are allowed to change your mind well after the fact. Specifically, you have until October 15, 2013 to recharacterize (unwind) a 2012 conversion.
Consider Splitting Up Large Accounts Before Converting
If you have a large-balance traditional IRA that you intend to convert into a Roth account this year, consider splitting it up into several smaller traditional IRAs. Then convert them into separate Roth accounts and follow different investment strategies for each one. If one of the new Roth accounts plummets in value next year due to poor investment performance, you can avoid an inflated 2012 conversion tax hit by recharacterizing that account back to traditional IRA status by October 15, 2013 (as explained immediately above). You can leave the better-performing accounts in Roth IRA status.”
As mentioned earlier, now is a better time than any to move forward with converting Traditional, SEP, and SIMPLE IRAs to Roth IRAs. However, just like any investment or major change, it is best to consult a tax advisor and/or financial planner before doing so. They will be able to fully determine the possible tax repercussions to making a move and converting accounts.
For more examples and to read the full article on Bizactions.com, click here.