The Absolutely Last Chance for a Massive Roth Conversion

The following is a guest post from Marotta Wealth Management.

A tax tsunami is coming at the end of this year. The higher your adjusted gross income (AGI), the closer you live to the coast where the tsunami will hit. This will be your last opportunity to safeguard your assets in a lifeboat and avoid getting swamped with taxes.

At the end of 2012, the Bush tax cuts will expire and tax rates will go up across the board. Even the 10% bracket will rise to 15%. There will once again be a marriage penalty on two-income families. A phaseout of itemized deductions and personal exemptions will return. The child tax credit will drop to half. The death tax will return at 55%. The capital gains tax will rise from 15% to 20%. Tax on dividends will increase from 15% to 39.6%.

And these are just the first wave of tax increases for 2013. Obamacare rolls out additional taxes through 2014. Taxes will be higher, but the country will still be in financial trouble. Like a merchant in danger of going bankrupt, the government is trying to raise prices to stay solvent. Cutting overhead, nearly always the solution, isn't even being considered.

It is time to take as much of your business elsewhere as you can before these rate hikes come into effect. Mercifully the government has provided a way for you to get a massive amount of your net worth out from under the growing tax burden. It is time to drive a Brink's truck through the legal loophole of Roth conversions this year. For those of you unwilling to take advantage of this opportunity, the road to serfdom is the default.

If you have an income over $100,000, this is the first year you can take money from your traditional IRA, pay tax as though that money is ordinary income and convert it to a Roth IRA. This procedure is called a "Roth conversion."

There are many reasons to do a Roth conversion this year. Each of them is a new tax burden being laid on the most productive members of society. Moving your money to a Roth IRA is putting your money in the only vehicle where it will never be taxed again.

Traditional IRAs get you a tax deduction now, and you can delay paying taxes until after your investment has grown. With a Roth IRA there is no tax deduction when you deposit the money. But the investments grow tax free rather than tax deferred. Qualified distributions from Roth IRAs are not subject to any income taxes. Roth IRA accounts are to your advantage if your tax rate will be higher when you withdraw the money than it was when you contributed.

In a Roth conversion you transfer your investment from your traditional IRA account into a Roth account. You pay tax on the value of what you transferred. The amount you can convert is unlimited. If you have traditional IRAs worth millions of dollars, you can increase your income this year by millions of dollars. If you are already in the top tax bracket, the conversion will not increase your marginal tax rate.

If you execute a Roth conversion now, you can change your mind later. If you decide the conversion wasn't worth it, you can move the money from the Roth account back to your traditional IRA account in a "Roth recharacterization."

Recharacterizing a Roth conversion can be done any time before you file your taxes, including the filing extension. So you can change your mind any time before October 15 of year 2. And you can decide to recharacterize part or all of what you converted.

If you convert this year, you can always recharacterize the conversion next year and undo it. But if you fail to convert this year, you miss forever being able to realize the income under the Bush tax cuts.

With a Roth IRA, you pay tax on the acorn. With a traditional IRA, you get a bigger acorn to start with, but you pay tax on the oak. Many families have actually lost money by investing in their traditional IRA when they were young and in a lower tax bracket, only to find themselves in a much higher bracket during their retirement. A year from now, we will all be in a higher tax bracket.

You are a good candidate for a Roth conversion in 2010 if you have the following characteristics. You have an AGI more than $100,000, so you are being targeted for future taxes. You have a large IRA that could be converted. You expect your tax bill to be higher in the future. You have sufficient taxable assets to pay the tax. You would like to reduce the value of your gross estate and leave a tax-free asset to your heirs. You are willing to pay estimated taxes and higher tax preparation fees.

Even thought this technique could boost your after-tax returns, be careful. Executing a Roth segregation account requires professional assistance. Such a technique should be just one small part of a larger comprehensive financial plan. And you should seek the guidance of a personal fee-only financial planner and certified public accountant (CPA) who have a legal obligation to act in your best interests. The laws are changing annually, and as a result so is the optimum path.

I published similar advice in 2010 when it looked like that would be the last year for conversions under the Bush tax cuts. Congress unexpectedly extended the lower rates for another two years. Those who have taken advantage of those two years have moved as much of their money as possible to Roth accounts and saved a tremendous burden of future tax hikes. Now that extension is expiring, and this time there probably won't be another extension.

Comments

[Apex]

Not The Absolutely Last Chance

These tax cuts will likely be extended again. They wait until the last paragraph to explain that they already made this warning once 2 years ago and were proven wrong. They claim Congress unexpectedly passed an extension. Kind of like they unexpectedly raised the debt ceiling and unexpectedly passed increased unemployment benefits and unexpectedly extended the payroll tax cuts.

Probably these tax cuts should expire. We cannot afford the deficits we are running. But Congress is a bunch of chickens and there is not a one of them that wants these Bush tax cuts to expire except on those making over 250,000. If it comes down to a fight over that particular group then it's possible these will not be extended if they say they won't extend them unless they exclude those over 250,000. But the Democrats will look very bad if they raise taxes on everyone by simply holding out for a tax increase on the rich and I doubt they are willing to take that gamble. That's why I would argue its unlikely they won't get extended again.

It is almost beyond professional fiduciary responsibility for this brokerage group to syndicate this article to thousands of outlets basically using scare tactics (for the second time in two years) about something that is probably more likely not to happen than it is likely to happen all while claiming that it is almost certain to happen. And if the Democrats lose the 2012 elections and then decide to let them all expire I would put pretty high odds that the Republicans put them back in during the first month of 2013.

I have excoriated this Marotta Wealth group before for their supposed "educational" articles. This is simply another example of them writing articles as if to appear unbiased when they have an underlying agenda to drive business to themselves. And there is nothing wrong with trying to drive business to yourself but doing so by these kinds of tactics is deceptive and makes them untrustworthy in my book.

[FMF]

Apex --

If it makes you feel any better, I've had two CPAs tell me exactly what Marotta is saying within the past six months. Perhaps they are trying to drive business too, but they had nothing to gain by giving me their opinion as there's no way for them to benefit from it.

[Apex]

FMF,

I may be overly skeptical, but I would expect a large money management firm to be tuned into the political environment a little better than CPA's. If not I am not sure how they can give their clients relevant advice. But even CPA's saying it in a fashion that implies certainty is unfortunate. I think often professionals err on the side of claiming the bad thing will happen rather than claiming it won't when they shouldn't be claiming either, but informing you of the possibility of both.

And to be clear I fully acknowledge the possibility that these tax cuts could expire. And along those lines advice to be prepared for that possibility is certainly something I would expect a firm like this to do. It's just the scare tactic tone that appears to be doing a hard push based on a far from certain event that bothers me.

Maybe it's just sloppy reporting but given they already mis-reported this once 2 years ago that is probably not acceptible. I guess to me whether Marotta knows they are overselling this or is ignorant of it is perhaps a distinction without a difference. Both cases are dis-qualifiers for a money adviser in my mind.

[Michael Goode]

This loophole has been nice for high-earnings folks. For a married couple with income over $150k or so and each one having a 401(k), it has been possible to contribute to a nondeductible IRA and then immediately convert it to a Roth IRA, thus skirting the income limits on Roth IRA contributions. So a couple like that can then put away an extra $10k this year in addition to the $34k from two maxed out 401(k)s. Over the three years this loophole has existed, that adds up to $30k in possible Roth IRA contributions when they really shouldn't have been able to contribute.

[Rick Francis]

This post makes it sound like the sky is falling. Let's do a reality check: Even if the Bush tax cuts expire- the nations tax policies are going back to what they were in the 90es. Were the 90es an economic disaster or a "road to serfdom"?

Even if you agree with this article I would seek out a financial advisor that doesn't sound like chicken little.

-Rick Francis

[Luis]

This is a personal finance article riddled with political innuendos. It is difficult to discern the knowledge from it (the money and taxes) and thus I need someone to follow up with me.

If you are making over 100k aren't you already near the top tax bracket? Should we not beware the dangers of conversion the writer speaks of? I imagine one has to have significant savings to pay for the tax increase on the conversion's affect on the 2011 MAGI.

Also, for long term IRAs that have been growing for at least 10 years- wouldn't you be taxing the growth of that investment? I don't doubt the benefits of Roth conversion (acorns to oak), but I also fail to see the entire truth behind a massive benefit of tax free growth when the existing growth will be taxed immediately?

[Kathy F]

I found the article informative, but too heavy handed on the scare tactics. I laughed when I read in the comments: "Congress is a bunch of chickens." Maybe true, but also maybe true that "Congress is a bunch of chickens running around in circles."

It is political gridlock and partisan infighting that sometimes prevents them from taking any action that worries me. Remember when there was no inheritance tax anymore due to their inaction. And they were willing to take our country to the brink of default. They could not agree on rational spending cuts and tax (or revenue) increases so they punted the big decision to the "Supercommittee" and now we have ended up automatic across-the-board spending cuts that may not make sense.
Of course, Congress can always change their mind on this. They don't seem to mind spending on earmarks or whatever new name they want to call them.

So it is important to know what is in store if they don't do anything, but we also need to take into account the prevailing political climate and politicians' inability to make the hard choices. And yes, it is an election year, so who knows what else can happen.

I am already maxed out with my TSP (govt 401k) and my Roth IRA. I bought I-bonds for the first time last year and bought some more this year (up to max amount) after reading that the taxes on the interest can be deferred.

[Josh Stein]

With how long it's taken Congress to act on anything (and furthermore how long it takes states to react to anything Congress acted on months after they should've), CPAs absolutely must have a better grasp of what's going on in Congress, as to how it relates to income taxes.

The worst answer anyone wants to hear is the most appropriate answer that must be given. "What's Congress going to do with taxes?"

"Truthfully, I do not know."

Yes, it appears they'd have to go up. And I'm sure they will in some method. But where? We can look into the tea leaves a little bit, but exact features? No. Not until at least after the November election.

[Tim]

I always love to see the line "Tax on dividends will increase from 15% to 39.6%." OK if your in the 39.6% bracket. Otherwise it becomes your marginal tax rate. Scare mongering article.

[Apex]

Luis,

"It is difficult to discern the knowledge from it (the money and taxes) and thus I need someone to follow up with me. "

"If you are making over 100k aren't you already near the top tax bracket?"

No, the top tax bracket kicks in at 388,000 for married and single and that tax rate is 35%. At 100K a single person is in the 28% federal bracket and a married person is in the 25% bracket.

"Also, for long term IRAs that have been growing for at least 10 years- wouldn't you be taxing the growth of that investment?"

Yes you absolutely would.

"but I also fail to see the entire truth behind a massive benefit of tax free growth when the existing growth will be taxed immediately?"

And that is the discussion of many debates on the issue. Not everyone agrees on the best course of action with respect to tax free growth on taxed money versus tax deferred growth on untaxed money. Usually it comes down to will you be in a higher bracket now or later. Some people probably have a good idea but most probably don't so a good bet would be to do a little of both.

[Bill]

Based on the article there is no risk to wait until the end of the year, check to see if the law gets renewed and then move if needed. To be fair the article also says you can undo the conversion (if the law is extended). Of course nothing stops the Gov't from just changing the status of a Roth (just like taxing Social Security or repossessing all your gold)

[Luis]

Apex, good to know. Perhaps not so massive after all.....

[Mark]

If the US would ever change to a flat tax anyone who converted to a Roth IRA will have made a big mistake.

Why don't I ever hear anyone talking about this when they write articles about Roth conversions?

[FMF]

Mark --

Because the chances of us moving to a flat tax are virtually zero?

[Young Limey]

The motley fool site has a calcualtor, which may help you determine if this is conversion is right for you. ("Should I convert my IRA to a Roth IRA?" under Roth IRA at the very bottom)

http://www.fool.com/calcs/calculators.htm?source=isesitlnk0000001&mrr=1.00

For me, an old 401k account with a previous employer, I end up with ~$900k keeping it in the 401k, compared to ~500k converting. Granted, the 500k is then tax free but I don't anticipate my taxes to be 40 some %, and I would have flexibility to pull money out over time etc to strategically account for my taxes)

Also agree that this article makes it seem like the sky is falling.

[jim]

I agree with Apex.

I also think Bill has a good point about waiting till the end of the year and seeing what the situation looks like then. There is zero reason to panic and do something today.

Whats the reference to Obamacare about? Is that just a random swipe at Obamacare? As far as I know theres no impact whatsoever from healthcare reform on IRA accounts or IRA distributions.

To Marotta's credit he does say that this advice is only applicable to high income earners with large IRA accounts and money to pay the taxes today.
But thats a very small % of the population. I think many more people would be making a big mistake to convert a traditional IRA to a Roth. Most people are in higher tax brackets during their working years than during retirement so they'd be voluntarily locking in higher taxes if they do a conversion.

[jim]

Is Young Limey any relation to Old Limey? ;)

[Young Limey]

no I'm just an Old Limey fan :)

[Apex]

@Mark,

Because the chance of that happening is zero. They have been talking about the flat tax for at least the last 20 years and we are no closer to having it, nor are we ever going to be. This is a topic that Republicans love to talk about around election time because it fires up the base, but it has no chance of passing in any Congress.

Do people understand that when you currently have a progressive tax system and switch to a flat tax system which is revenue neutral that by definition it must raise tax rates on the lower rate brackets while lowering rates on the upper rate brackets? CEO's that make 5 million would see a huge tax cut. Blue collar workers that make 60,000 would see a significant tax increase.

Headlines out just today report that 49.5% of American's now pay no federal income tax at all. Many will argue that's exactly why we need a flat tax. But that will create an outcry about hurting the poor. Herman Cain's 9-9-9 plan brought exactly those kinds of complaints and in fact a number of Republicans were quietly making the exact same argument. His plan just had no practical chance of passing and it was also woefully short of raising even the revenue we now raise. It was just a political stunt to wave a carrot that was merely a mirage. There was nothing real or remotely possible about 9-9-9.

In addition to half of people paying nothing in federal income taxes we have the top 10% of wage earners paying 71% of all the federal income tax. Do you want those 10% to pay less? Because if they do the rest of us have to pay more? Is that what you want? Do you think that can pass?

In a December 2011 Bloomberg Washington Post poll 70% of people said they want those making over $250,000 to pay more in taxes. 53% of self identified Republicans said they want those making more than $250,000 to pay more in taxes. So how exactly would we pass a bill that had the tax rate go down for those over $250,000 (they currently pay a rate of 31% moving quickly up to 35%) and to make the tax rate go up for the 49.5% who pay nothing? (presumably the flat tax rate would need to be higher than nothing)?

If you want to argue the government spends way to much and can do with far less revenue that's not a flat tax argument. That's a spending argument. You won't make any progress on that issue either by the way but even if you did there is still the same argument about whether or not the 50% who pay nothing should have their taxes raised while the top 10% have them lowered significantly. That just isn't going to fly regardless of how much less money the government spends. Hint: the government is going to be spending a lot more money in coming decades with the baby boomers starting to retire, not less.

So I ask the big question:

With all these facts why do people think a flat tax has a snowball's chance in a really hot hades of ever becoming the law?

Wishful thinking doesn't seem to begin to explain it.

[Apex]

FMF,

You stole my thunder! :)

[Jclimber]

Why does Mariott say "If you have an income over $100,000, this is the first year you can take money from your traditional IRA, pay tax as though that money is ordinary income and convert it to a Roth IRA. This procedure is called a "Roth conversion."

This is not the first year, the AGI limit for Roth conversions was lifted in 2010. I have done several since then.

[MonkeyMonk]

Probably because they recycled the same "sky is falling" article they published back in 2010. Another horrible article from an often horrible contributor to this blog.

[Apex]

@MonkeyMonk,

That is exactly correct. I noticed the first year reference too and figured the exact same thing. Namely that this was a re-write of the previous article from 2010 and the author was so sloppy they didn't even bother to clean up the references to get it updated for 2012. Pretty pathetic really.

[Matt]

@Apex

Nice use of "excoriated"

[Luis]

Horrible is right, disappointed my neighbor would write such an interesting topic with really bad taste. At least we got the Huguely trial conviction spot on! :)

[Tim]

It didn't take much checking to find that: "The income limit for Roth IRA conversions is permanently eliminated"

http://www.kiplinger.com/columns/ask/archive/faqs-on-the-new-roth-conversion-rules.html

The only question would be what will the tax rate be in future years on a Roth conversion.

I'm sure those who have already done a large Roth conversion and want to keep putting into a Roth are using this to skirt the Roth MAGI limit. Contribute to a non-deductable IRA then do a Roth conversion on that amount after a few days.

[Jclimber]

@Tim - Exactly! I do this every January for my Roth & my wifes Roth. This way I can convert to my 2012 Roth immediately instead of waiting until I know my MAGI (which wouldn't be know for sure until taxes are filed the following year). This is a good thing to do if you think you will be close to or over the MAGI direct Roth limit. We have no other IRA's so no taxes are due when we do these conversions.

[Luis]

@ Tim Woot! ....and No CPA needed to do that, amen!

[SA]

I don't like to be one of those "complain about the topics" commenters, since I know I could just go elsewhere, but as a regular reader of FMF, I really didn't appreciate the political nature of this post. It could have been written totally without all the swipes at Obama and the evil Democrats and Obamacare, etc. and still gotten the point across about considering the Roth conversion before taxes theoretically go up. I'm not saying I agree one way or the other, but seriously, we're getting enough political vitriol everywhere else -- can't we avoid that crap in this usually-friendly community?