subject: Alternative Minimum Tax Payers And The Fiscal Cliff - Now Is The Time To Consider A Roth Conversion [print this page] Individuals with IRAs and 401(k) accounts have the opportunity to do a Roth conversion before year-end, potentially saving thousands of dollars of taxes on their retirement plans by paying taxes now and not having to pay any taxes in the future. This opportunity deserves serious consideration by all taxpayers, but particularly so for individuals who currently are in the Alternative Minimum Tax or may be in the future.
What happens upon conversion?
The dollars an employee contributes to a regular 401(k) and a regular IRA generally are pre-tax. This means that income taxes have not yet been paid on these contributions; instead, taxes are paid when distributions are taken from the plan at retirement. Along with the original contributions, the investment earnings in the plan likewise are taxable when withdrawn. In contrast to these regular plans, a Roth plan is funded with after-tax dollars, so there are no taxes due at the time the funds are withdrawn, both for the original contributions as well as the accumulated earnings.
At the time of conversion from a regular plan to a Roth, income taxes must be paid on the full amount converted. With this prepayment of taxes, no taxes then are due when the money is taken out.
The key question
The most critical part of a Roth conversion analysis is the comparison between the taxpayers current tax bracket and the tax bracket in which he or she expects to be in retirement. The question is how does one go about making this comparison?
Current tax brackets
Under the current 2012 tax brackets, for the married filing jointly status the Regular Tax 28% bracket is reached at $142,700 of taxable income, the 33% bracket at $217,450, and the 35% bracket at $388,350. Compare this to the AMT bracket of 26% for Alternative Minimum Taxable Income up to $175K, and 28% for everything over that level. Looking at these brackets reveals something very interesting: AMT brackets are significantly lower at roughly comparable levels of income.
This fact alone is the reason individuals currently in the AMT need to give serious consideration to doing a Roth conversion. The potential for a 7% savings from differences in the tax brackets (28% vs. 35%, e.g.), or even more, definitely is there.
Tax brackets - there will be change
Making things a little more difficult, however, is the fact that tax brackets likely will change. The Fiscal Cliff means that, if Congress does not act soon, on January 1 Regular Tax rates will increase, and it will have been even more attractive to do a Roth conversion today rather than waiting until next year. Equally as important is the fact that tax brackets for most folks will be less in retirement than what they are today, simply due to the nature of our graduated tax rate system.
Conclusion
With year-end and the Fiscal Cliff approaching, every individual with a 401(k) or a regular IRA has a real opportunity to save taxes. This opportunity is much greater for taxpayers who currently are paying the Alternative Minimum Tax than it is for those who are not. A little time spent making a Roth conversion analysis easily could result in thousands of dollars in tax savings.
