Without Congressional action by December 31, 2012, over 35 Bush-era tax cuts will be eliminated, which means, among other things, that income tax rates will go up. Many so-called tax experts seem to think that Congress won’t act until after the election. Taking a position on tax law changes and thereafter having to compromise BEFORE your election could mean that you do not get re-elected.
If that is the case, how do you plan? As a Florida estate planning attorney, I have found that my clients appreciate any advice that allows for flexibility. That way, they will not need to come back in six or eight months to re-do everything!
Along those same lines, for the last few years, advisors have talked to their clients about converting their traditional IRAs to Roth IRAs. The reasons are numerous:
- You can have tax-free income in retirement – which means you don’t have to worry as much about future income tax rates.
- There are no required minimum distributions (RMDs).
- You have access to the dollars you converted penalty-free before age 59½ (subject to a five year holding period in certain instances).
- Conversions are allowed after age 70½.
- You can create a tax-free legacy for your heirs.
As with many things in life, downsides exist when you convert. For example, when you convert, you pay income tax on the value of your traditional IRA at ordinary income tax rates. To make matters a bit more difficult, you will need to come up with the tax liability from other funds. For some of our clients, they do not have taxable assets (such as bank accounts or an investment account) from which they can make a withdrawal to pay this income tax liability.
In addition, earnings distributions from a Roth IRA may be subject to taxes and a 10% penalty if the account is less than five years old and the owner is under age 59½.
Presumably, if tax rates go up next year, then paying tax now may make sense so that your converted account can grow tax free. What makes the Roth conversion unique is the ability to “reverse” your conversion. For example, if your account balance declines substantially after the conversion due to poor investment performance, you may want to undo the conversion. The deadline to recharacterize your conversion is the filing deadline of the date your tax return is due (October 15 of the year following the year of conversion, if your return is extended).
Have more questions, give me a call. I would love to help.
