See Section 179 Expensing and Bonus Depreciation in action in the example below.
Dr John Smith, Dentist
Income: $300,000 with a $500,000 SEP IRA
Purchases new $300,000 Pano X-Ray Machine and laser equipment with $50,000 down signing a seven-year, 4-percent note
Uses bonus depreciation with five-year straight-line depreciation for the balance
Dr. Smith can expense $139,000 by electing a Section 179 deduction. He can take an additional deduction equal to 50 percent of the remaining $161,000 ($80,500) and 20 percent of the remaining $80,500 balance, or $16,100, for the first year under a five-year straight-line method. The total first-year deduction would be $235,600. This $235,600 income deduction could be used to offset a very large conversion from Dr. Smith's SEP IRA. This strategy can be especially appealing to owners of medical/dental practices and manufacturing companies.
Net Operating Losses From A Business
In addition to depreciation elections, business owners such as sole proprietors, limited liability companies, family limited partnerships, S-corporations or partnerships that have operating losses could offset the conversion income. This conversion opportunity applies to business owners that report a business loss on Schedule C of their personal tax return. For clients who participate in an S-corp or partnership, an operating loss is calculated on Part II of Schedule E of their tax return. This loss is then reported in the income section of the 1040. Any conversion amount is also reported in the income section of the 1040, potentially resulting in an offsetting situation. It is also important to remember that net-operating losses can be carried forward for up to 20 years. Many many clients may currently be carrying forward these losses, and it may make sense to harvest the loss in a single year instead of carrying it forward for years to come.
Consider the following example:
John Smith owns a manufacturing company.
He is currently carrying forward a net operating loss with a remaining balance of $500,000
IRA assets of $1,000,000
This is an opportunity where John could potentially utilize a large portion or potentially all of his net-operating-loss carry forward to offset a current-year Roth conversion. It is important to note converting too large of an amount could crowd out other deductions, so it is important the client consult his tax advisor in calculating the optimal conversion amount.
As 2012 comes to a close, many business owners and high-income investors will likely be examining their financial situation, given they soon could be facing a new tax paradigm. Understanding the opportunities could have lasting impacts on many investors' long-term financial plans. While Roth conversions will be attractive to many investors, as always, each clients situation is different, making it wise to consult a tax professional when implementing these or other Roth conversion strategies.
Jim Foster, CFP, is director of Prudential Annuities' Advanced Planning and Solutions team. He works extensively with financial professionals, CPAs and attorneys to help them understand the complexities and opportunities of retirement planning, income distribution and estate planning.