Roth IRA conversions: A touch of class - Business Management Daily

The tax pundits have been saying it all year: Now is the time for a Roth IRA conversion. With the prospect of higher taxes in 2013, plus the imposition of the new 3.8% Medicare surtax on investment income, it makes more sense than ever for well-off individuals to convert a traditional IRA to a Roth.

Strategy: Don?t put all your eggs in one basket. Rather than using one account, set up multiple Roth IRAs based on the asset classes of the current investments in your traditional IRA. You could end up with a half-dozen or more Roth accounts.

The reason for this technique is to provide flexibility in case you want to recharacterize Roth funds at a later date. It?s like giving yourself a ?get out of jail? card in Monopoly.

Here?s the whole story: When traditional IRA distributions are received, you?re taxed at ordinary income rates on the portion of the payout representing deductible contributions and earnings. Beginning in 2013, these rates are scheduled to increase, with the top tax rate reaching 39.6% (as opposed to 35% in 2012).

Conversely, qualified distributions from a Roth at least five years old are 100% tax-free. (Prior distributions are taxed under special ?ordering rules.?) For this purpose, ?qualified distributions? are payments made after age 59?; on account of death or disability; or used for first-time homebuyer expenses (up to a lifetime limit of $10,000). Thus, the main tax attraction of Roth IRAs is on the back end.

Of course, you must pay tax on a conversion, which is why wealthy individuals are being advised to convert before 2013. When you add the upcoming 3.8% Medicare surtax on top of the maximum 39.6% federal income tax rate scheduled for 2013, the effective federal tax hit on a 2013 conversion could be as high as 43.4%, not even counting state income tax.

The tax liability is based on the value of the traditional IRA funds on the day of the conversion.

Note, however, that you can recharacterize a Roth back into a traditional IRA if it suits your purposes. For instance, if the value of your new Roth IRA?s investments declines after the conversion, you will have ?overpaid? the tax. ?

For example, you might allocate large-cap stocks to one Roth, mid-cap stocks to a second, small-caps stock to a third and bonds to a fourth. Then, if the value of one or more of the four Roth accounts drops after the conversion, you have until Oct. 15 to recharacterize that account (or those accounts) back to traditional IRA status. Leave the other accounts alone.

Example: Dividing your assets

Suppose you set up four Roths in 2012 as stated above. Say that the value of each Roth on the conversion date is $250,000 and you?re in the 35% tax bracket. So you pay $87,500 in tax (35% of $250,000) on each conversion.

Next year, the value of Roth IRA #1 drops to $150,000, Roth IRA #2 increases to $300,000 and Roth IRAs #3 and #4 are still worth $250,000. Accordingly, you can recharacterize Roth IRA #1 back into traditional IRA status. That means you won?t owe the $87,500 of 2012 federal income tax that would otherwise be due from converting that account to Roth status.

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