With all the recent changes to the U.S. tax code, it’s a good time to revisit different tax planning strategies. One strategy I’m often asked about is whether a Roth conversion is a good idea. The universal answer to that question is “maybe.” Unfortunately, there isn’t a simple rule of thumb that applies to everyone. There are many factors that need to be examined, and my goal is to tell you the most common reasons you might want to do a Roth conversion.
Before I do that, it’s important to note a particular change in our tax code with the passage of the Tax Cuts and Jobs Act (TCJA) of 2017. In the past, a recharacterization was done if you needed to “undo” the Roth conversion. Starting in 2018 and beyond, this is no longer allowed for Roth conversions. An exception is if you make a Roth contribution, and then learn that you earned too much income during that year. A recharacterization will still be allowed in this case so that you’re not subject to the excess contribution penalty tax. (more…)
Please Note: With the passage of the Tax Cuts and Jobs Act of 2017, beginning in 2018 a recharacterization of a Roth conversion is no longer allowed. You may still recharacterize any Roth conversions done in 2017, but this will no longer be allowed for Roth conversions done in 2018 or beyond.
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.
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