Roth Conversions Ahead of 2013 Tax Increases

September 20, 2012
By Kaye A. Thomas

High-income individuals have special reasons to consider Roth conversions before the end of 2012. They can benefit in two ways:

  • Scheduled increases in income tax rates could make it more expensive to convert to a Roth after 2012.
  • These same increases, together with other increases targeting investment income, could significantly enhance the post-conversion benefits.

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Possible tax increases. As this book goes to press in August 2012, a number of major tax increases are scheduled to take effect in 2013. The unprecedented nature of these increases is such that the popular press has been referring to a coming Taxmageddon.

Republicans generally oppose these tax increases, but we won’t know how much strength they’ll have to prevent them until after the election. Bear in mind that these increases are already written into the law, so it will require an act of Congress, signed by the President, to undo them. Proceed­ings in the Senate often require 60 votes, so Republicans won’t necessarily get their way on all these issues even if they seize control of the Senate and the White House.

Congress will almost certainly hold a lame duck session after the election (a session in which the outgoing Congress, including members who are retiring or have been defeated for re-election, may enact legislation). This session will occur before the end of 2012, so it will be possible to do a Roth conversion after learning the outcome and before the end of 2013. It’s possible, though, that some of the most important issues will be left for the next Congress to resolve. In this case, you’ll have to act based on your best guess as to the possible outcome.

Keep in mind that you can undo a 2012 conversion in 2013 if things don’t turn out as planned, but you can’t do a 2012 conversion after the end of the year. When in doubt, convert.

With those thoughts in mind, let’s look at the tax changes that are scheduled to occur. This is a partial list, focusing on changes that have the most impact on the conversion decision.

Income tax rates. The Bush tax cuts, which reduced the highest individual income tax rate from 39.6% to 35%, are scheduled to expire after 2012. President Obama has proposed retain­ing the lower rates for singles with income below $200,000 and couples below $250,000, but allowing rates to rise for those with higher levels of income. Some Democrats have expressed support for even higher rates for individuals with higher levels of income (a millionaire’s tax, for example). These changes in rates could increase the tax cost of a Roth conversion by 13% or more (13% of the tax, that is, not 13 percentage points of tax).

Taxation of investments. As explained in Chapter 10, a Roth conversion has the effect of expanding your retirement account. It’s as if you moved some of the money you would otherwise be investing in a taxable account into a tax-free environment. This means the overall benefit of a Roth con­version increases when the treatment of taxable investments becomes less favorable—and it’s scheduled to become a lot less favorable in 2013.

  • The higher tax rates described above would affect any investment income treated as ordinary income, such as interest paid by bonds or certificates of deposit.
  • The maximum rate of tax on long-term capital gain is scheduled to rise from 15% to 20%. That’s a 33% increase in the tax cost of cashing in a capital gain.
  • Qualified dividends, taxed at a maximum rate of 15% in 2012, lose their special treatment in 2013, so the highest rate on this income would go to 39.6%.

What’s more, for the first time, a 3.8% Medicare tax will apply to net investment income of high-income individuals ($200,000 for singles, $250,000 for couples) beginning in 2013. Interest, dividends and capital gains are all affected. The tax doesn’t apply to distributions from retirement accounts (including conversions, which are treated as distributions), but income from distributions counts as part of your overall income in determining whether you’re a high-income individual who has to pay this tax on your capital gains and other investment income.

These changes send a clear message. You should strongly consider a Roth conversion if all of the following apply to you:

  • Your income is high enough to be affected by these tax increases.
  • You have a traditional retirement account that can be converted to a Roth.
  • You have other investments, not sheltered within a retirement account, that can be cashed in to pay the tax on a Roth conversion.

Even without the impending tax increases, a Roth conver­sion may well be a good move for someone in this position. The possibility that these changes will take effect provides added impetus to this strategy.