Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog – Part 2 of 6

Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog – Part 2 of 6

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Per last week’s post, the 2010 “tax tail wag the dog” provision that enabled 2010 Roth IRA converters to avoid inclusion of the income from their conversion on their 2010 income tax returns and instead defer 50% of it to 2011 and the other 50% to 2012 was the driving force behind many Roth IRA conversions in 2010. As stated in the post, this was despite the fact that, until the 2010 Tax Relief Act was enacted in the last two weeks of the year which left tax rates unchanged for 2011 and 2012, converters were facing potential higher tax rates in those two years on their deferred income.

When the dust settles, was it really such a big deal that you could defer 50% of the income from a 2010 conversion to 2011 and the other 50% to 2012? In certain cases, this did enable some people to have their conversion income taxed at a lower tax rate due to the splitting of their income over two years, however, in many situations, this wasn’t the result. These individuals simply received the benefit of postponing payment of 50% of their tax liability for one year and the other 50% for two years. Yes, you can earn interest on 50% of those funds for an additional year and another 50% for an additional two years, however, with our current abysmal interest rate environment, how much additional after-tax earnings will you actually receive?

Now that Roth IRA conversions are no longer “on sale,” i.e., if you do a conversion in 2011 and future years, you must report 100% of the income from your conversion in the year that you convert your traditional IRA to a Roth IRA, why should you do a Roth IRA conversion? As pointed out in the February 8 and 15, 2010 posts, The Ideal Roth IRA Conversion Candidate – Parts 1 and 2, there are several specific scenarios whereby the income from a Roth IRA conversion will result in little or minimal income tax liability. These specific fact patterns, once they are recognized, analyzed, and determined to be applicable to one’s situation, translate into slam-dunk Roth IRA conversion opportunities.

Assuming that you aren’t an “ideal Roth IRA conversion candidate,” why should you derail the investment growth of your nonretirement assets and instead use these valuable funds to pay income tax today on the income from a voluntary IRA distribution that you wouldn’t otherwise be required to pay for many years down the road in a lot of cases? After all, isn’t one of the basic guiding income tax principles that has been engrained in all of us from our earliest tax planning days is to defer income and associated taxation as long as possible? The answer to this question is yes – in most cases. The exception is when the projected long-term economic benefits from an alternative course of action exceed the projected benefits to be derived from not pursuing that course of action.

In the case of a Roth IRA conversion, what are the potential long-term economic benefits? There are three primary benefits to be derived, with the first one being the most important and overriding reason in most cases for doing a conversion: (1) elimination of taxation on 100% of the growth of Roth IRA conversion assets, (2) elimination of exposure to required minimum distributions on traditional IRA funds converted to a Roth IRA, and (3) potential reduction in taxation of Social Security benefits.

Benefit #1 will be discussed in Part 3 of this post, with the other two benefits being the subject of Parts 4 and 5, respectively. Part 6 will work through an example to demonstrate how the potential economic benefits to be derived from a Roth IRA conversion compare to the upfront cost, or tax liability, associated with a conversion.

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