The Absolutely Last Chance for a Massive Roth Conversion

with 9 Comments

A tax tsunami is coming at the end of this year. The higher your adjusted gross income (AGI), the closer you live to the coast where the tsunami will hit. This will be your last opportunity to safeguard your assets in a lifeboat and avoid getting swamped with taxes.

At the end of 2012, the Bush tax cuts will expire and tax rates will go up across the board. Even the 10% bracket will rise to 15%. There will once again be a marriage penalty on two-income families. A phaseout of itemized deductions and personal exemptions will return. The child tax credit will drop to half. The death tax will return at 55%. The capital gains tax will rise from 15% to 20%. Tax on dividends will increase from 15% to 39.6%.

And these are just the first wave of tax increases for 2013. Obamacare rolls out additional taxes through 2014. Taxes will be higher, but the country will still be in financial trouble. Like a merchant in danger of going bankrupt, the government is trying to raise prices to stay solvent. Cutting overhead, nearly always the solution, isn’t even being considered.

It is time to take as much of your business elsewhere as you can before these rate hikes come into effect. Mercifully the government has provided a way for you to get a massive amount of your net worth out from under the growing tax burden. It is time to drive a Brink’s truck through the legal loophole of Roth conversions this year. For those of you unwilling to take advantage of this opportunity, the road to serfdom is the default.

This is the last year you can take money from your traditional IRA, pay tax under the lower Bush tax rates, and convert it to a Roth IRA. This procedure is called a “Roth conversion.”

There are many reasons to do a Roth conversion this year. Each of them is a new tax burden being laid on the most productive members of society. Moving your money to a Roth IRA is putting your money in the only vehicle where it will never be taxed again.

Traditional IRAs get you a tax deduction now, and you can delay paying taxes until after your investment has grown. With a Roth IRA there is no tax deduction when you deposit the money. But the investments grow tax free rather than tax deferred. Qualified distributions from Roth IRAs are not subject to any income taxes. Roth IRA accounts are to your advantage if your tax rate will be higher when you withdraw the money than it was when you contributed.

In a Roth conversion you transfer your investment from your traditional IRA account into a Roth account. You pay tax on the value of what you transferred. The amount you can convert is unlimited. If you have traditional IRAs worth millions of dollars, you can increase your income this year by millions of dollars. If you are already in the top tax bracket, the conversion will not increase your marginal tax rate.

If you execute a Roth conversion now, you can change your mind later. If you decide the conversion wasn’t worth it, you can move the money from the Roth account back to your traditional IRA account in a “Roth recharacterization.”

Recharacterizing a Roth conversion can be done any time before you file your taxes, including the filing extension. So you can change your mind any time before October 15 of year 2. And you can decide to recharacterize part or all of what you converted.

If you convert this year, you can always recharacterize the conversion next year and undo it. But if you fail to convert this year, you miss forever being able to realize the income under the Bush tax cuts.

With a Roth IRA, you pay tax on the acorn. With a traditional IRA, you get a bigger acorn to start with, but you pay tax on the oak. Many families have actually lost money by investing in their traditional IRA when they were young and in a lower tax bracket, only to find themselves in a much higher bracket during their retirement. A year from now, we will all be in a higher tax bracket.

You are a good candidate for a Roth conversion in 2012 if you have the following characteristics. You have an AGI more than $100,000, so you are being targeted for future taxes. You have a large IRA that could be converted. You expect your tax bill to be higher in the future. You have sufficient taxable assets to pay the tax. You would like to reduce the value of your gross estate and leave a tax-free asset to your heirs. You are willing to pay estimated taxes and higher tax preparation fees.

Even thought this technique could boost your after-tax returns, be careful. Executing a Roth segregation account requires professional assistance. Such a technique should be just one small part of a larger comprehensive financial plan. And you should seek the guidance of a personal fee-only financial planner and certified public accountant (CPA) who have a legal obligation to act in your best interests. The laws are changing annually, and as a result so is the optimum path.

I published similar advice in 2010 when it looked like that would be the last year for conversions under the Bush tax cuts. Congress unexpectedly extended the lower rates for another two years. Those who have taken advantage of those two years have moved as much of their money as possible to Roth accounts and saved a tremendous burden of future tax hikes. Now that extension is expiring, and this time there probably won’t be another extension.

As part of the nonprofit NAPFA Consumer Education Foundation, we are offering a presentation titled “Last Chance to Put Your Money Where It Will Never Be Taxed Again” at the Charlottesville Senior Center at 1180 Pepsi Place on Wednesday, February 15, from 5:30 to 6:30 p.m. We will show you how to execute a Roth conversion in 2012, how much it could save, and how to compute how much of the conversion to keep and how much to recharacterize in 2013. The talk is free and open to the public. A question-and-answer session will follow.

Subscribe to Marotta On Money and receive free access to the presentation: Last Chance for a Massive Roth Conversion.

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.

9 Responses

  1. Jerry

    I have read a couple of Mr. Marotta’s articles regarding Roth Conversions and I think that I should do Roths rather than the traditional IRA’s that I have in my account already . I have approx. 17 Ira’s with a value of approx. $325,000 all with various companys.

    Can you give me any help on how to transfer the Traditional IRA,s or better yet to be able to leave the Roths with the present companys I have them in at present.

    On March 14, 2013 I will turn 701/2 and I would like to make this change before I need to start withdrawing my IRA accounts.

    Thanks for any help you can give me.


    • David John Marotta

      Greetings Jerry,

      As you can see from the subsequent articles and posts, everything is dependent on your base taxable salary how much you should convert. A second factor is how much the Roth accounts has appreciated by the time you have to make your decision.

      Given your $325,000 account, you could convert five accounts of $65,000 each and make the decision of how much to keep next year.

  2. Ron

    Mr. Marotta: re: Roth conversions: what about state income taxes? For example someone in the highest tax bracket in a state with an 8% marginal rate who may retire in 10 years to a state with no income tax.

    • David John Marotta

      Greeting Ron,

      A client with a different state tax rate in the future acts in the same ways as a different federal tax rate in the future. If the state tax rate will be higher in future years it lowers the hurdle rate of appreciation a Roth account must achieve in order not to be better recharacterizing.. If the state tax rate will be lower in future years it raises the hurdle rate of appreciation a Roth account must achieve in order not to be better recharacterizing.

  3. Juli

    I’m a little lost on this sentence: “You are a good candidate for a Roth conversion in 2010 if you have the following characteristics.”

    Is this recycled material and is it relevant to 2012?

    • David John Marotta

      Greetings Juli,

      I’ve corrected that typo. It should have been 2012. The year 2010 was the last time tax rates were threatening to rise and Congress hit the snooze button for two years. This year (2012) Congress may hit the snooze button again, or the lower rates might finally expire.

  4. HF

    Hello John:

    what do you think about converting as much as possible up to the next marginal tax increase limit.? so if someone earns say 80, 000, converting 98,000 only this year, to prevent going into a higher marginal tax range, then converting the remainder in subsequent years, always not converting enough to move into the next marginal tax range?

    thank you

    • David John Marotta

      Greetings John,

      Generally converting to the top of your current bracket is appropriate. If a Roth account appreciates enough after conversion (e.g. if it doubles) it may be worth keeping even if it pushes you into a higher tax bracket. And with a Roth conversion you can decide to keep it or recharacterize it after the tax year is over but before you file your tax return. The computation is dependent on current and future tax brackets. If the tax law is changing or your situation is changing it changes the hurdle computations.

  5. Dale

    John, now that we know what the tax situation is…it appears to me that the lower tax brackets can continue to convert IRAs to Roth at the 2012 tax structure?
    Happy New Year