Hedging higher tax rates with Roth conversions

With the Bush-era tax cuts set to expire at the end of 2012, many investors are seeking ways to hedge against a potential increase in tax rates for 2013 and beyond. One option that should not be overlooked is the use of Roth conversions.

A Roth conversion allows you to pay tax on the converted IRA assets now, with those assets then growing tax-free for the rest of your life. It is generally preferable to defer taxes for as long as possible, but in a situation where tax rates may increase in the future, it may be worth locking in the taxes at today’s rates. For example, the top tax rate in 2012 is 35%; In 2013, the top tax rate may be as high as 43.4% (39.6% top marginal rate plus the 3.8% “Medicare surtax”). If tax rates don’t increase, you can always undo the conversion by recharacterizing the Roth back to a traditional IRA. As long as a recharacterization is done by the extended due date of the tax return (October 15th), you’ll just be back to where you started.

It is also important to recognize that a Roth conversion may bump you up into a higher tax bracket in the year of the conversion, depending on the amount converted. In that case, you should consider a partial conversion, where you only convert enough to stay within your current tax bracket. This is where the assistance of a tax professional can be invaluable.

Everyone’s situation is different, and whether a Roth conversion makes sense for you will depend on your particular circumstances and desires. Your financial advisor and CPA can help you weigh the costs and benefits of such a strategy to determine if it is right for you.

Solution for a lack of choices in company sponsored retirement plans

I use your investment strategy for my Roth IRA and Rollover IRA.  My current employer uses Prudential for my company’s 457 plan.  Looking at the options, I cannot seem to use your allocation strategy due to a lack of choices.  Do you have any suggestions?

A recurring theme in most plans is a limited number of investment options.  This restricts your ability to properly allocate and diversify your account.

If you find yourself in this situation the allocation tactic described below is a simple and practical way to get your portfolio on track.

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Can you benefit from a “Backdoor” Roth?

Since their introduction in 1998, Roth IRAs have become an important part of the financial planning landscape. They offer the unique ability for investors to grow their money tax-free, not simply tax-deferred like traditional IRAs. They also avoid required minimum distributions so they can grow undiminished for many years. In fact, Roth IRAs are wonderful assets to pass along to the next generation, where they can continue to grow tax-free even longer.

Until recently, this unique retirement vehicle was available only to individuals with incomes below certain thresholds. “High-income” individuals could not contribute to Roth IRAs or convert traditional IRAs into Roth IRAs. Some of this changed in 2010, when the Roth conversion income limitations were permanently repealed. Now, anyone (regardless of income) can make a Roth conversion.  However, the Roth contribution limitation was not repealed. This means that if your income exceeds the levels in the table below, you cannot contribute directly to a Roth IRA—but you can achieve the same result by first contributing to a non-deductible traditional IRA and then converting it to a Roth IRA.

This presents an interesting opportunity for high income individuals, who perhaps yearn to save beyond their 401(k) or 403(b) retirement plans or who simply desire the account diversification that comes with adding a Roth vehicle to their retirement mix. (more…)

It’s not too late to consider a Roth conversion

The end of the year is a busy time for most of us. Don’t forget to consider whether the Roth conversion might be worth your while. This year’s deadline, December 31st, is quickly approaching.

The income limitations to convert to a Roth have been repealed for this year and beyond, so anyone with an IRA is now eligible. Also, don’t forget that for 2010 conversions only, you have the option of recognizing the conversion income in the subsequent two years (2011 and 2012). This allows you to receive the benefits of a Roth IRA immediately while delaying the tax hit for a few years.

If you convert now and later change your mind, you can “undo” the conversion with a recharacterization—so you are not necessarily locked into the conversion if you do it this year. You have until the extended due date of your tax return (i.e. October 17, 2011) to recharacterize the conversion if you change your mind.

You may consider doing partial conversions—converting just enough each year to use up the rest of a particular tax bracket, like the 15% or 25% tier. Although this requires more work and planning each year, it’s a great way to gradually gain Roth exposure while sensibly controlling the tax impact.

Your financial advisor or CPA can help you decide if a Roth conversion is right for you. You can also find more information on the pros and cons of a Roth conversion in my article “Roth IRAs: To convert or not to convert.”