Thursday, September 8, 2011
This article analyzes the pros and cons of making a Roth IRA conversion, the mechanics to do the conversion, and how to undo it. The strategy takes on new importance in the years 2011 and 2012 with the looming 3.8% health care tax on investment income beginning in 2013. IRA owners may want to lock in the lower "Bush income tax rates" of 2011 and 2012, especially if they can make the conversion at time when the value of the IRA assets are low because of volatile swings in the stock market. A Roth IRA conversion will be less attractive after 2012 if it could bring a person’s income over $200,000 ($250,000 on a joint return) and thereby trigger that tax. Although retirement plan distributions are exempt from the 3.8% surtax, the conversion could cause other investment income to be subject to the tax.
The downside of a Roth IRA conversion is that it takes taxable income that would have been spread over many years of retirement and accelerates the taxation of that income into one year (e.g., 2012). Despite the up-front tax cost, Professor Hoyt identifies five situations when the benefits of the conversion can exceed the cost. These include being free from required minimum distributions (RMDs) after attaining age 70 ½ and state income tax savings for people who live in one of the nine states that has no state income tax (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming) or in a state that exempts retirement income from tax (e.g., Illinois) and who might move to a different state.
The article was written in 2010 before the "Bush Tax Cuts" were extended into 2011 & 2012, so the principal update to the analysis in the article is to substitute "2011-2012" for 2010.