As we enter the summer of 2012, few people are concerned with year-end matters. However, when the ball drops on New Year’s Eve, there is a scheduled increase in income tax rates nonetheless. As a result, now may be a great time to “Roth” IRAs.
Roth IRA Conversion
A Roth IRA is similar to a traditional IRA in that the assets in the IRA build without income taxation. However, there are a few features that are different from a traditional IRA. There is no income tax deduction upon contribution to a Roth IRA. So, why would one want to invest in a Roth IRA? Neither the assets, nor the growth of the assets, are subject to income taxation upon withdrawal.
While there are income limitations upon contributions to a Roth IRA, there is no income limitation for conversions from a traditional IRA to a Roth IRA. Thus, for those with significant traditional IRAs or with the ability to rollover a qualified plan to a traditional IRA, they could create a large Roth IRA by converting their existing plan.
Income Tax Timing
With income tax rates scheduled to increase next year, now may be the best time in the foreseeable future to convert. The converted amount would be subject to income taxation at this year’s lower income tax rates.
In future years, when distributions are taken, not only will they avoid the income tax hike occurring next year, they will not be taxed at all.
No Estate Tax on Income Tax
This is also a good estate planning tool. Because they are income tax-free, Roth IRAs are particularly potent assets to leave to beneficiaries. Essentially, it is like being able to set aside money today to pay the beneficiary’s income tax later. However, it’s even better. The income tax which was paid in the conversion process is removed from the estate.
Thus, the Roth IRA conversion process has reduced estate tax concerns by pre-paying income tax and thus shrinking the size of the taxable estate.
As we’ve seen, converting a traditional IRA to a Roth IRA in 2012 may make a great deal of sense for Income Tax and Estate Tax reasons. Throughout the rest of 2012, I’ll keep you current on ways to take advantage of the ever-narrowing opportunity available before “Taxmageddon” at the end of this year.
Stephen C. Hartnett, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (858) 453-2128
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