Year-End Tax Planning for IRAs

During 2011, many news reports focused on federal budget deficits and government debt. Will taxes be increased to address those issues? That’s certainly a possibility. If you have large amounts of pretax money in a tax-deferred traditional IRA, you may owe tax on future withdrawals at a high tax rate. Moreover, if you die and leave your traditional IRA to loved ones, your beneficiaries might owe hefty taxes as they draw down the inherited IRA.
One way to avoid or reduce this potential problem is to convert all or part of your traditional IRA to a Roth IRA. After five years and after age 59½, all withdrawals from the Roth IRA are tax free. (For Roth IRA beneficiaries making withdrawals from an inherited account, the age 59½ rule does not apply. The age 59½ rule does apply, however, to a surviving spouse who treats the deceased spouse’s Roth IRA as his or her own Roth IRA.)
Example 1: Lynn Mason, age 50, has $100,000 in a traditional IRA. This account contains only pretax money. If Lynn converts her traditional IRA to a Roth IRA in 2011, she will report $100,000 of taxable income from the conversion. By the time Lynn reaches age 59½, she will be able to withdraw any amount, free of income tax.
Even if her Roth IRA is $150,000, $200,000, or more, Lynn can take tax-free withdrawals, regardless of income tax rates in effect at that time. There are several advantages to converting a traditional IRA to a Roth IRA before year-end 2011:
Income tax rates You know the tax rates for 2011— they range from 10% to 35%. If you convert a traditional IRA to a Roth IRA this year, the tax rate will be in this range. Tax rates have been much higher in some prior years, and they might move back up, perhaps as early as 2012.
Five year clocks
Converting a traditional IRA to a Roth IRA at any time in 2011 starts the five year clock at January 1, 2011. Therefore, you’ll meet the five year requirement in just over four years, on January 1, 2016. In reality, you may start two, five year clocks with a Roth IRA conversion in 2011: one for the 10% early withdrawal penalty period and one for taxation of withdrawn earnings.
Example 2: As previously illustrated, Lynn Mason converts a $100,000 traditional IRA to a Roth IRA in 2011 and pays income tax on a $100,000 conversion. Going forward, Lynn can withdraw up to $100,000 from her Roth IRA at any time without owing income tax, because she has already paid tax on that money.
However, Lynn is only 50 years old, as noted. Therefore, any withdrawal before the five year mark will be subject to a 10% penalty. If Lynn pulls out $90,000 in December 2015, for instance, she will not owe income tax but will owe a $9,000 early withdrawal penalty. By waiting until January 2016, Lynn can pull out up to $100,000, totally tax free. The early withdrawal penalty lapses five years after a Roth IRA conversion, even if you are still younger than age 59½, which is the usual date this penalty expires.
Example 3: Suppose that Matt Davis, age 58, converts a $100,000 traditional IRA to a Roth IRA in December 2011. In 2015, Matt’s Roth IRA has grown to $130,000. Matt withdraws the entire amount. In this example, Matt has not met the five year requirement, which he would have met on January 1, 2016. Nevertheless, Matt will owe no income tax on the $100,000 he converted because he already has paid income tax on that money, and he will not owe the early withdrawal penalty because he will be 62 then, and, thus, older than 59½.
However, Matt wishes to withdraw the full $130,000 from his Roth IRA. The last $30,000 will be earnings. That $30,000 will be subject to income tax because Matt did not meet the five year requirement, but will not be subject to a 10% penalty because he will be older than 59½. If Matt had waited until January 1, 2016 to make the withdrawal, he would owe no tax at all on the withdrawn earnings.
Reversing course
In each of the examples in this article, a taxpayer converted a $100,000 traditional IRA to a Roth IRA and, consequently, reported $100,000 of taxable income. These taxpayers might have to pay as much as $35,000 to the IRS because of the conversion and additional amounts in state as well as local income tax. Individuals with larger traditional IRAs may have to pay even more on Roth IRA conversions.
Fortunately, you can reduce the tax you’ll owe. A Roth IRA conversion can be “recharacterized” until October 15 of the next year. A 2011 conversion can be reversed, in full or in part, up to October 15, 2012. The amount recharacterized goes back into your traditional IRA.
Recharacterization offers “look- back” tax planning opportunities. Suppose that Lynn Mason fills out her 2011 tax return and discovers that she has $120,000 of taxable income, as a single taxpayer, without counting her Roth IRA conversion. In 2011, the 28% tax bracket for single filers goes up to $174,400 of taxable income.
In this scenario, Lynn could decide to cap her Roth IRA conversion
at $54,000, keeping her in the 28% tax bracket. Thus, she could recharacterize $46,000 worth of her conversion (46% of the amount then in her Roth IRA) back to a traditional IRA. After waiting for more than 30 days, Lynn can reconvert that money to a Roth IRA in a 2012 conversion.
Total recall Suppose that Lynn Mason implements a $100,000 Roth IRA conversion in late 2011, as illustrated. In mid-2012, the stock market has fallen, and Lynn’s Roth IRA has dropped to $80,000. Lynn decides she does not want to report $100,000 in taxable income to get a Roth IRA now worth only $80,000. As a result, Lynn recharacterizes her entire conversion and avoids paying any tax on the transaction.
Say that Lynn recharacterizes on October 10, 2012. On or after November 10, 2012, she can reconvert to a Roth IRA. Assuming that her IRA’s value has not changed by then, Lynn will have a Roth IRA and owe much less tax than she would have owed with a 2011 conversion.