Year-End Planning - Part 2: Roth Conversion
November 1, 2012
The looming potential of the 2013 "Fiscal Cliff" has raised many questions from our clients. Regardless of who wins next week's election, potential tax law changes have many of our clients questioning what they can do today to protect their assets from the potential impact from higher taxes in their portfolio in the future. One consideration is converting Traditional IRAs into Roth IRAs, also known as a Roth Conversion. This highly complex and popular question is the subject of part two of our year-end planning series.
Most investors are very familiar with Traditional IRAs. While most are familiar with the name, "Roth IRA," many aren't as familiar with the mechanics of a Roth IRA as its Traditional IRA counterpart. This is due, in part, to the length of time that Roth IRAs have been in existence and the somewhat restrictive eligibility requirements to qualify to contribute.
Roth IRAs came into existence through the passing of the Taxpayer Relief Act of 1997, named after its chief legislative sponsor, Senator William Roth. There are three differences between Traditional IRAs and Roth IRAs: tax treatment of the contribution, tax treatment of the withdrawal, and income eligibility cut off.
Tax Treatment of Contribution:
The contributions to a Roth IRA are 100% not tax deductible, whereas the contribution to a Traditional IRA can be 100% deductible. If you are covered by a plan at work, married, and making under $92,000 ($58,000 for single filers), your Traditional IRA contribution is 100% deductible. You contribution is partially deductible up to $112,000 ($68,000 for single filers).
Tax Treatment of the Withdrawal:
Traditional IRA's grow tax deferred. Withdrawals from a Traditional IRA are taxed as ordinary income. Any non-deductible contribution to a Traditional IRA comes out without taxes. Roth IRAs grow tax-free. In other words, the withdrawal from a Roth IRA is made without any taxes whatsoever. As a result, there are no mandatory withdrawals from a Roth IRA. Traditional IRAs must begin to be withdrawn upon at age 70 ½.
Income Eligibility Cut Off:
In order to be eligible to make a full contribution to a Roth IRA, a married couple could make no more than $173,000 per year ($110,000 for a single filer). For example, a married couple making $200,000 can't contribute to a Roth IRA. Anyone, at any income level, can make a contribution to a Traditional IRA.
Things to Consider...
Determining if it is advantageous to convert a Traditional IRA to a Roth IRA can be complicated due to the many different variables that need to be considered. The following variables should be taken into consideration when making your decision: 1) How much you have in retirement assets versus taxable assets; 2) The balance of your Traditional IRA; 3) Your time horizon; 4) Cash flow needs; 5) Your current marginal tax rate; 6) Your ability to pay the income taxes with non-IRA money; 7) Your estate planning objectives.
Advantages, should you convert
The most obvious advantage is the growth of your Roth IRA assets without any taxes whatsoever. The Roth IRA grows without taxes and can be withdrawn without taxes. This becomes an even more pronounced advantage when coupled with no IRS Required Minimum Distribution (RMD) amounts imposed on Roth IRA investors.
There are also some significant estate planning reasons to convert to a Roth IRA as long as you have income sources outside of your retirement account to support your lifestyle needs. Investors who convert a Traditional IRA into a Roth could possibly reduce their estate taxes and eliminate the income tax their heirs would otherwise have to pay on withdrawals taken from an inherited Traditional IRA.
Due to the complexity of the subject, we would be happy to run an evaluation to see if converting your Traditional IRA to a Roth would be financially sensible. We will also want to get your accountant involved as well. Please let us know as soon as possible if you are interested in this evaluation.
As always, we welcome your feedback and are happy to answer any questions you might have.
Jeffrey J. Powell
Managing Partner, Polaris Wealth Advisers, LLC
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