Monday, January 7, 2013

Roth Conversion Part II – New Option for Tax Diversification

2010 provided us all with a unique potential opportunity to convert existing IRA savings assets to Roth IRA regardless of earned income. This new tax freedom spawned much analysis on the current tax bill created by conversion versus the future of tax-free growth. Our practice held numerous workshops to discuss the pitfalls and the process. The new tax bill passed last week provides for a new Roth conversion consideration, as participants in tax-deferred retirement plans that also have a Roth feature will now have the option to convert tax-deferred savings to Roth.

Contributions to a traditional 401(k) (403b, 457, etc.) account are tax-deferred, with taxes paid at ordinary income rates when the money is withdrawn in retirement. When savers put money into a Roth 401(k) account, they pay taxes on the money upfront in exchange for tax-free withdrawals later.

The converted amount would be subject to income tax in the year of conversion, but, under a special rule, would be deemed to be exempt from the 10% tax on early distributions, regardless of whether the participant is under age 59 1/2. It does not appear that conversions would be subject to the 3.8% tax on the net investment income of higher income taxpayers.

It's important to note that unlike Roth IRA conversions, which can be reversed by the following October 15th, plan conversions are irrevocable and can't be undone.

So, should you consider conversion? Maybe…Consideration factors include your age; tax bracket now versus tax-bracket in retirement; whether your deferred retirement savings is earmarked for your use or for heirs; whether or not you have the funds outside of your retirement plan to pay the tax bill on conversion.

As usual this can be a sticky situation. Let us know if we can help you weigh the upside & downside of conversion for you situation.