Tax cuts and Roth conversions

The extension of current tax rates should have encouraged 2010 year-end Roth conversions, especially for those who had been on the fence.

As most advisers know, beginning Jan. 1, 2009, everyone qualified for a conversion to a Roth individual retirement account. All previous income and filing status restrictions were repealed permanently. More high-income clients are seeing the advantage of paying tax now to create an income-tax-free retirement account for themselves or their beneficiaries. With tax cuts on the books for at least 2011 and 2012, the Roth conversion conversation becomes even more interesting.

The big question for those who converted in 2010 is when to include the income from the conversion. All taxpayers who made a Roth conversion last year have a choice: take a special two-year deal where the conversion income is spread equally over 2011 and 2012 or opt to include all the income in 2010. It was a choice available only for 2010 Roth conversions. Now all income generated from a Roth conversion will be included in income for the year the conversion takes place.

With the tax cuts extended to 2011 and 2012 (meaning the income tax rates for those years will be the same as in 2010), and if you expect a client’s income to be about the same or lower in those years, it makes sense to take the two-year deal. Think about it. If you could buy something now and pay for it two or three years from now at no extra cost, with no interest, why on earth wouldn’t you take the deal?

The only reason some clients should consider paying all the tax in tax year 2010 is if their 2010 taxes figure to be much lower than what they will pay in coming years. Perhaps increased deductions or business losses (net operating losses that could be used to reduce or eliminate the tax on a 2010 Roth conversion) in 2010 or simply because their overall income was much lower than it will be in future years.

If your clients felt that their 2011 and 2012 income will be much higher (from, say, a bonus or raise or increased business income), then it probably pays to include all of the Roth conversion income in 2010. Even though rates might be the same this year and in 2012, a client’s higher income in those years could push them into a higher marginal tax bracket. In such cases, waiting to pay later would cost more in the long run. Of course, if your client remains in the highest tax bracket no matter what, then you’re back to the virtual no-brainer of splitting the income over 2011 and 2012. The bottom line, though, is that the tax cuts will add clarity to the decision.

With the tax cut extension, and all other factors’ being equal, chances are, the tax paid in 2011 and 2012 actually will be slightly lower than the tax paid for last year, even though the rates will be the same. That’s because of the annual inflation adjustments that determine income tax brackets.

In 2010, for example, a couple filing married-joint remained in the 15% tax bracket until taxable income exceeded $68,000. In 2011, those same taxpayers will be in the 15% tax bracket until taxable income exceeds $69,000, due to the inflation adjustment. In 2012, the 15% tax bracket likely will be extended even further. As a result, the actual tax paid will be slightly lower — plus your clients will have the added benefit of holding on to their money longer and earning interest, all while the Roth IRA is growing tax-free. It’s like the government is giving everyone an interest-free loan to build a tax-free savings account.

The new tax bill brings one other Roth conversion bonus: estate-tax-free Roth IRAs for many clients. With the estate tax exemption rising to $5 million ($10 million per couple), inherited Roth IRAs will not only be income-tax-free but also estate-tax-free for most heirs. That’s a big deal.

Converting will set the stage to take advantage of a unique tax situation that most investors may never see again. Remember, too, that a 2010 Roth conversion can be undone (re-characterized) until Oct. 17. I still believe that long-term tax rates for most taxpayers will increase, especially for those with higher income. Now is the time to capitalize on a political situation that is creating the opportunity of a lifetime to build totally tax-free retirement savings.

Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.