In 2010, Roth IRA conversions were the talk of the town. You could not pick up a newspaper, magazine or any publication without reading an article about this incredible strategy since the $100,000 modified adjusted gross income limitation had been removed. The press made it seem like the strategy was ideal for just about anyone who had a traditional IRA and enough assets outside of their IRA to pay the income taxes generated by the conversion.
To this day, the majority of people who have initiated a Roth IRA conversion still do not know if they made the right decision. With the probability that income tax rates will increase next year, those people may look back and say, “Yes, I did the right thing.” However, we will not truly know if the strategy was advantageous for many years. In fact, in most cases these investors will not know if they made the right choice until they die. This is because there are so many factors that work into the equation of whether it was worth pre-paying all of those taxes years before you were required, and in some cases, whether you had to pay the income taxes at all.
Fast-forward three years as we enter 2013. We are now faced with an additional set of factors that need to be considered when recommending a strategy to convert traditional IRA assets to a Roth IRA.
The most obvious factor advisors will need to consider is the new 3.8 percent Medicare surtax that will apply to net investment income if your client’s modified adjusted gross income (MAGI) is over a certain threshold. The threshold amounts are $200,000 for taxpayers filing single and $250,000 if you are married filing jointly. Although the actual taxable income generated by the conversion will not be subject to this new tax, it will increase your client’s MAGI, which in turn could push them over the income threshold causing a portion, if not all, of their net investment income to be subjected to the Medicare surtax.
Another factor to consider in your analysis of whether to initiate a Roth IRA conversion is the effect this strategy will have on your client’s Medicare Part B premium. Although the breakpoints for Medicare premiums have been around for several years, this issue is often overlooked in the Roth IRA conversion analysis since it is not seen as a direct tax on the income generated by the conversion. Medicare Part B premiums for 2013 are $104.90 per month if your MAGI does not exceed $170,000, however your premium could jump as high as $335.70 per month if your MAGI is in excess of $428,000.
Consider the following scenario. Suppose you decide to convert $20,000 of traditional IRA assets to a Roth IRA, knowing that this amount does not push your client into a higher marginal tax rate in their specific situation—but you forget to consider how this additional $20,000 of MAGI may affect their Medicare premiums. If the additional $20,000 pushes your client’s MAGI over the $170,000 “breakpoint,” your client’s combined Medicare premiums (for both spouses) could increase $1,008 for the future year, which equates to an additional five percent “tax” on that $20,000 of conversion income.
Beginning in 2013, advisors may need to consider the phase-out of personal exemptions and itemized deductions again. For the past three years, we have enjoyed the elimination of these phase-outs. President Obama proposes to allow both reductions to resume in 2013 for higher income taxpayers—single filers with AGI over $200,000 and joint filers with AGI over $250,000. As a refresher, the personal exemption phase-out reduces the value of your personal exemption(s) by two percent for each $2,500 above a specified income threshold. The limitation on itemized deductions cuts itemized deductions by 3 percent of AGI above specified thresholds, but not by more than 80 percent.
The tax that could have the greatest effect on whether to implement a Roth IRA conversion strategy is the estate tax. If the top estate tax rate increases from 35 percent to 55 percent, and the exemption amount decreases from $5.12 million to $1 million, this could have a dramatic effect on the amount of assets that clients pass to the next generation. Assuming that your client is not going to consume all of his retirement assets during his lifetime, a Roth IRA conversion is an excellent strategy to remove embedded income taxes from his taxable estate. If the estate-tax exemption amount is reduced in 2013, the advantages of this strategy become even more pronounced.
The decision to convert traditional IRA assets to a Roth IRA should never be based on the simple question, “Will you be in a higher tax bracket in the future?” The detailed analysis needs to incorporate many factors. The true long-term benefit of this strategy spans multiple generations. In addition to your client’s own current and future marginal tax rate, you need to consider their children’s (assuming they are the beneficiaries of your IRA assets) future marginal tax bracket. If your client is in the highest marginal tax bracket, but their children—who will eventually inherit these assets—are in the lowest marginal tax bracket, will it really benefit your client and their children to prepay income taxes on these assets?
What if your client is making charitable bequests in their will? Is there really a benefit to prepay income taxes on these assets that could be left to charities that have a zero percent income tax rate?
Are Roth IRA conversions still a viable strategy for your clients? Of course they are! Just be sure to perform a detailed analysis of their current and future situation, as well as the future situation of the beneficiaries of their IRA assets. 2013 will bring a new set of factors that you will also need to take into consideration in your analysis. Make sure that you are confident that a Roth IRA conversion is an appropriate strategy for your client’s specific situation because it is likely that you will not be able to quantify the advantages (or disadvantages) for many years to come.
Source – fa-mag.com