Year-End Planning Idea – Roth IRA Conversion

December 3, 2012

December 31, 2012 is the deadline to convert a traditional IRA to a Roth IRA.

December 31, 2012 is the deadline to convert a traditional IRA to a Roth IRA while still ensuring it is taxed at the lower 2012 income tax rates assuming the Bush-era tax rates expire. Now is the time to review your book of business and identify clients who may be impacted by possible future tax increases. Executing a Roth IRA conversion before 12/31/12 could be a good solution to compliment their future retirement income needs.

Why your clients should consider a Roth IRA conversion before 12/31/12

A Roth IRA conversion works well for IRA clients that are expected to be in a higher income tax bracket when they plan to retire and access funds from their retirement assets. Distributions that are deemed as a "qualified Roth IRA distribution" are free from income tax. Of course, the challenge that many individuals face when deciding if they should convert in 2012 is the uncertainty of future income tax rates beginning 2013 and beyond.

How much higher could income tax rates go?

Without any legislative intervention between now and the end of this year, the ordinary income tax rates are scheduled to rise.

In addition, the passage of the Health Care Reform Act (aka Patient Protection and Affordable Care Act) created new taxes that will be applied to certain higher income taxpayers beginning in 2013. These new taxes include both:

  • 0.9% payroll tax on wages.
  • 3.8% tax imposed on net investment income.

While the new taxes mentioned above won’t directly apply to the actual Roth IRA conversion, the conversion amount will be part of the MAGI that may push the clients into the applicable threshold (i.e. $200,000 for single filers and $250,000 for married couples filing jointly) and be subject to the additional 3.8% tax.

Roth IRA Overview

  • Tax-free distributions - Qualified tax-free distributions must meet both of the following requirments:
    • The Roth IRA has been established for five years either through a contribution or a conversion.
    • The Roth IRA owner has experienced any one of the following: attainment of age 59½, become disabled, died, or incurred first-time homebuyer expenses.
  • Not subject to Required Minimum Distribution (RMD) – Unlike a traditional IRA, Roth IRA owners are not required to take annual RMDs.
  • Roth IRA distribution and taxation of social security benefits – Qualified tax-free distributions from a Roth IRA are not included as income and will not affect the taxation of social security benefits.
  • Tax-free inherited Roth IRAs – Following the death of the Roth IRA owner, qualified tax-free distributions can be paid to beneficiaries.  Non-spouse beneficiaries may elect to stretch distributions by taking RMDs based on their single non-recalculated life expectancies.

Can a Roth conversion be undone?

If, as an example, the tax rates do not increase, or the converted Roth IRA has declined in value, the Roth IRA owner may recharacterize (reverse) the Roth IRA back to a traditional IRA. A 2012 Roth IRA conversion can be recharacterized until as late as tax due date plus extension, as long as the taxpayer has filed their tax return on a timely basis.

How can I learn more?

A useful tool to analyze a Roth IRA conversion is our Roth IRA conversion calculator which enables you to calculate and generate personalized reports that contain retirement savings projections based on different conversion scenarios.

Picture of Steve Chmelka

Steve is a Senior Retirement Strategies Consultant with the Retirement Solutions Division at Pacific Life. He brings more than 25 years of industry experience in financial planning and wealth management, including detailed knowledge of both employer-sponsored retirement plans and retirement-planning strategies.

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