As 2013 approaches, many investors are facing the real possibility of higher marginal tax rates. The highest federal tax bracket is currently scheduled to increase from 35 percent to 39.6 percent on January 1. The prospect of higher taxes has created renewed interest in Roth conversions. As these looming marginal tax increases draw closer, higher-income investors will be asking themselves if the conversion opportunity will ever be as good as it is today.
While many investors may be eager to take advantage of the tax benefits of a Roth conversion, the reality of writing the check creates a great deal of apprehension. Remember, a Roth conversion is fully taxable at an individual's marginal tax rate. Although that means potentially writing large checks today to the IRS, in a rising tax world these same individuals could likely be facing far larger income tax liabilities in the near future.
Fortunately for some clients there are tactical strategies that could reduce the overall tax bite in a conversion year. Should a client have the ability to implement some of these strategies, the opportunity to convert retirement accounts to a Roth IRA deserves a closer look. This is especially true given the real possibility that Roth conversions could get more expensive in the near future. For clients who can take advantage of the following strategies, now might be the perfect opportunity to execute a conversion.
For those who are charitably inclined, making charitable contributions in the year of a Roth conversion may help offset the cost. When clients make charitable contributions and take itemized deductions, they receive an income deduction in the amount of the gift. It is important to be aware that the amount of the deduction may be limited depending on the size of the gift. Deductions for gifts of appreciated stock, for example, are limited to 30 percent of Adjusted Gross Income (AGI). Deductions for cash gifts have a 50 percent limitation. If a client gifts above these thresholds, the IRS will allow any unused portion of the deduction to be carried forward for five years.
Adjusted Gross Income: $200,000
IRA Balance: $1,000,000; Non Qualified Stock: $300,000 with a basis of $200,000
If John is charitably inclined and is looking at the possibility of converting a portion of the IRA to a Roth, an accelerated charitable gift maybe a good strategy.
In this situation John could make a charitable gift of the full $300,000 stock position today. Since John is contributing securities to a charity, his deduction is limited to 30 percent of his AGI. In this case he will continue to carry forward the unused deduction each of the next four years until the entire $300,000 has been deducted. Each year he could effectively convert an equal amount from his IRA to a Roth IRA without generating any additional tax liability. In making a gift of the securities, John also avoids capital gains tax on the gifted stock. This strategy may be of particular interest to not only those who are charitably inclined, but also those who are looking to reduce future required minimum distributions (since Roth IRAs are not subject to RMD during the owner's lifetime) or provide an income-tax-free asset to their beneficiaries. SInce the conversion amount is included in AGI while the charitable deduction is an itemized deduction, there may be impacts on taxation of Social Security benefits or itemized deductions that are based on AGI, such as medical expenses.
Accelerated Depreciation Elections
For business owners, there is a unique opportunity to shield IRA conversion income by purchasing of capital equipment. This is done through two separate accelerated depreciation methods known as bonus depreciation and Internal Revenue Code (IRC) section 179 expensing. In 2012, these two elections can be combined for an even greater deduction. These strategies, while easy to implement, have the ability to create significant deductions to offset a Roth conversion.
Section 179 permits the acceleration of an expense related to the purchase of capital equipment in the year in which the purchase occurred rather than spreading the deduction over the depreciable life of the asset under the Modified Accelerated Cost Recovery System (MACRS). It can be utilized for both new and used equipment. For 2012, the Section 179 expensing limit is $139,000. The cap for qualifying property is $500,000. The election can made utilizing IRS form 4562.
In 2010 President Obama signed into law the "Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act." This act placed special depreciation opportunities for new capital equipment purchased and placed into service in tax years 2010- 2012. For 2012, a bonus depreciation election of up to 50 percent can be made.