On January 2, 2013 the American Taxpayer Relief Act (ATRA) was signed into law making changes to many areas of the tax law, including ordinary income tax, capital gains tax and estate, gift and GST tax. In light of the law’s new provisions, there are several planning strategies that advisors should revisit with clients to see if they have been impacted by the changes made by ATRA and if so, whether those changes make such a strategy more or less favorable. One common strategy that should be reevaluated is the Roth conversion.
For some clients, the extension of the Bush-era tax rates makes converting now a better move than had been anticipated. For instance, married clients with $250,000 of income may have been anticipating not making Roth conversions based on the President’s campaign goal of increasing taxes in 2013 for those with more than $250,000 of income.
Now however, those clients can convert up to $200,000 per year without pushing themselves into a higher tax bracket. Of course, this could create a reduction of itemized deductions and personal exemptions that begin to be phased out for joint filers at $300,000 of adjusted gross income (AGI) and single filers at $250,000 of AGI, so advisors should continue to evaluate each client on a case-by-case basis.
One benefit of ATRA’s “permanent” extension of the Bush-era tax cuts for most clients is that stretching out conversions over a number of years may make more sense than in previous years. In the past, clients may have been more inclined to make large conversions in order to lock in the “low” income tax rate at the time. Now however, that becomes less of an issue and converting over time may make more sense. Some clients may even choose to recharacterize 2012 conversions made in anticipation of higher 2013 income tax rates in order to take advantage of this approach.
Example:
In 2012, Jim, a single taxpayer, had taxable income of $300,000 excluding his Roth conversion and an IRA worth $500,000. As the end of the year approached, Jim believed that it was likely that in 2013 the tax rates would be higher for single taxpayers with taxable income in excess of $200,000 so he decided to convert his entire IRA and lock in the 35% maximum income tax rate in effect during 2012.
As we now know, Jim lucked out and the 2012 tax rates were extended for single filers with taxable income below $400,000. Therefore, Jim may want to recharacterize a good portion, say $400,000, of his 2012 conversion and reconvert it back to a Roth IRA over time. For instance, assuming Jim’s income remains relatively stable, he can reconvert $100,000 per year over the next four years without pushing himself into the new 39.6% bracket. Note: Jim would have to wait more than 30 days after recharacterizing to reconvert any of the funds he previously converted in 2012.
While any appreciation in Jim’s traditional IRA over the next four years would ultimately be taxable, spreading the liability out over a number of years might make the smaller annual tax bills easier to stomach than the single large bill Jim would otherwise have to pay when he files his 2012 tax return. Although the conversion income could phase out some of Jim’s itemized deductions or personal exemptions, the ordinary rate he’d owe on his conversions would be no higher than what he would have paid in 2012.
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