|By PAUL SULLIVAN|
WHEN it comes to making financial decisions to save on taxes, you don’t usually get a do-over. Just ask all those people who rushed to make large tax-free gifts to family members at the end of last year before a historically high exemption was set to expire. Not only did the exemption not end, but it was increased for 2013. And there was no way to get those tax-driven gifts back.
One exception to the no-do-over rule involves the Roth I.R.A. When people move money from a tax-deferred I.R.A. to a tax-free Roth, they pay income taxes on the amount they transfer. Because the move has huge tax implications, the federal government gives people a chance each year to change their minds if they do it within a certain period of time.
Over the last three years, planners pushed the conversion idea especially hard with clients because of certain tax advantages. And some people might have been pushed harder than they should have been. Those who made the conversion to Roth — and now regret it — will have until
But undoing it, even if it makes financial sense, may be hard for some people to even consider. For many tax-driven investors, it probably took a lot of convincing from accountants and advisers to get comfortable with paying up to 35 percent of the account value in federal taxes.
With the deadline to “recharacterize” a Roth, to use industry jargon, fast approaching, I wanted to take a look at some of the questions surrounding Roths before and after
THE ROTH RUSH To understand why voluntarily paying a large tax bill on retirement savings was attractive last year, you have to first understand the difference in how money put into and taken out of traditional and Roth I.R.A.’s is treated.
In a traditional individual retirement account, money is put in before taxes are paid; when it is withdrawn after a person turns 59 ½, it is taxed as income. Those who do not need the money in their 60s can wait until they are 70 ½, at which point there is an annual required minimum distribution that is calculated based on life expectancy. But that will make the withdrawals bigger and the tax rate higher. If that I.R.A. is passed on to heirs, they still have to pay income tax on the withdrawals and the account will be considered part of the estate.
In a Roth I.R.A., money is put in after taxes are paid and is later withdrawn tax free. There are no required distributions. It is also included in an estate, but when it passes to heirs they can make withdrawals free of income tax.
Therefore, to convert from a traditional I.R.A. to a Roth I.R.A., you need to pay the income taxes you did not pay when that money was originally put in. The amounts can be large and can put people into a higher tax bracket for the year. The certainty of higher income tax rates in 2013 made the conversion attractive last year: high earners, in particular, could pay federal tax at 35 percent instead of the current 39.6 percent. (They also owed state taxes, but the amount depended on their state.)
“It takes a client who understands the importance of converting something from tax-deferred to tax-free and paying the taxes upfront,” said
CHANGING YOUR MIND Yet even though proponents say there are people for whom such a conversion makes a lot sense, there are others who did not think it through fully.
People who should not undo their Roth conversion — and may want to consider additional conversions if they can stomach the tax — generally fall into three categories: They have other investments to live on. When they are forced to take distributions, they will end up paying tax at a higher rate on money they do not need. Or, ultimately, they would like to leave their retirement account to their heirs.
There is a subset that could temporarily be in a low tax bracket, and a conversion for heirs might make sense.
People who might want to reconsider are those who find that their life has changed in an unexpected way and they need that tax payment back, and those who have seen the value of their Roth conversion fall.
People who watched their account’s value fall after converting to Roth are in an intriguing situation, since chances are not all of their investments went down. To anticipate this,
“Maybe they have
BEST STRATEGIES For accountants and advisers who work with wealthier clients, the conversion of large I.R.A.’s into Roth accounts resembles the plans advisers put in place to diversify large concentrations of a single stock: they happen methodically, regularly and in a highly disciplined way. And they will continue even though income taxes have risen.
“It’s much more powerful for my client at 45 than at 65,” he said, pointing out that it takes years for investment gains to surpass the tax losses. The exception is someone who is doing the conversion for heirs who will have a longer time horizon.
Another benefit comes to people who own small businesses and can use operating losses to offset the tax on larger Roth conversions, said
“Coming off a couple of bad years, there were quite a few businesses that had carry-forward, net operating losses,”
(These losses are treated differently than capital gains losses, which are limited at
FUTURE CONVERSIONS While many of the long-term planning reasons for converting a traditional I.R.A. to a Roth still hold true even with higher income tax rates, there are more caveats.
“Depending on where your income levels are and how they creep up, those things start to come into play,”
But since all of these conversions are a bet on the future, it is hard to know what next year or the year after might bring with taxes, and it will matter when the money comes out of these accounts.
|Copyright:||Copyright 2013 The New York Times Company|
|Source:||New York Times Digital|