By Amy Feldman
NEW YORK Nov 9 Many taxpayers are delaying
their year-end decisions until they see what Washington does
with a host of expiring tax measures, including those affecting
dividends and capital gains.
Yet one of the biggest year-end tax moves is relatively
removed from the headlines: whether or not to convert a
traditional Individual Retirement Account (IRA) to a Roth IRA.
The Roth IRA is partly a play on income-tax rates - you make
contributions to a Roth with after-tax money and then don't owe
income tax again. If you expect your personal tax rate to be
higher when the money comes out than it was when it went in,
it's a better deal than a traditional IRA, which allows you to
defer the tax hit until you make withdrawals in retirement.
Even though tax gurus love Roths, such accounts made up just
6 percent of the $4.9 trillion in IRA assets at the end of last
year, according to the Investment Company Institute. A lot of
people may want to consider converting at least part of their
IRAs into Roths.
That is because you will not pay taxes on the earnings
within your Roth account as long as you wait until you're over
age 59-1/2, and the account is at least five years old, before
you start making withdrawals of those earnings.
State tax treatment of IRAs typically follows federal law,
so the effect of IRA decisions can be magnified in states with
high income tax rates.
Younger people can do much better with a Roth IRA because,
earnings may outstrip initial contributions as they build up
year after year. The simple rule here is, the longer you can
leave money in a Roth, the better.
The biggest benefits go to those who use Roths for estate
planning and do not actually need to tap their accounts in
retirement. Roth IRAs are not subject to rules that force
traditional IRA-holders to begin drawing down assets at the age
of 70-1/2. Account holders who never use the money and bequeath
it to their children or grandchildren will be transferring those
tax-free breaks to the younger generations.
This is why financial planners and tax advisers often
recommend that wealthy older people who expect to leave an
inheritance - even those already in retirement - use a Roth IRA
as a simple, tax-efficient way of passing money to future
generations. However, Roth IRA balances are included in tallying
estates for estate tax purposes.
"We did quite a bit of modeling on Roth conversions, and
what we found is that the conversion is beneficial, but in many
cases the break-even period is about 20 years," says Richard
Baum, a tax partner at Anchin, Block & Anchin, in New York.
"If a client wanted to do the conversion for the benefit of
a grandchild, that would make sense," Baum said. "But you do
need a long period of time to recoup the tax costs."
A Roth IRA conversion calculator, such as this one from fund
giant Vanguard (),
can help you make the decision about whether to convert. You
may want to ask a tax adviser for a more personalized analysis.
For some people, doing a Roth conversion will move them into
a higher tax bracket or into the alternative minimum tax - an
income tax enacted to make sure the rich pay some minimum amount
of tax that is increasingly hitting the middle class.
How much tax you will owe on your 2012 federal tax returns
depends on what type of IRAs you hold. Over the years, some
people have made after-tax contributions into traditional IRAs,
so it is possible to have a fully tax-deferred IRA or one that
is only partially tax-deferred.
If you own only IRAs that have been funded with
non-deductible contributions, then you will owe tax on the
earnings only, since you already paid tax on the original amount
when you made the contributions. But if you have only IRAs with
deductible contributions, you will owe tax on the full amount
you convert, since you contributed on a pre-tax basis.
If you contributed both ways - as many people have - then
you will need to figure out your tax hit based on the pro-rata
share of each, a rule that prohibits you from cherry-picking
among your accounts. The upshot is that your tax bill could
range from relatively minor to around one-third of the value of
the assets you're converting.
The psychological part of paying taxes early has deterred
many people from doing a conversion. If you need to take the
money out of your Roth or a tax-deferred account to pay the tax
bill on the conversion, do not do the conversion, experts say.
Any benefits from the Roth would be outweighed by pulling the
cash out, especially if you wind up owing penalties for taking
money from a retirement account before the age of 59-1/2.
And what if you pay the tax up front, and then the market
goes down, shrinking the assets you converted? While there's
little you can do about the investment decision, there is an out
for tax purposes: Simply undo the conversion in a process that
the Internal Revenue Service dubs recharacterization. So, after
going through all of those calculations, you may find yourself
with a do-over.