Understanding the full tax cost of Roth IRA conversions

 

(As with any tax related topic, PLEASE make sure you fully understand your particular situation.  The descriptions below are general in nature and additional conditions may apply to you!  Please consider this educational, not specific advice for you to follow!)

There has been a rapid rise in the conversion of traditional IRA’s to Roth IRA’s over the last several years.  As mentioned in a previous post, nearly $65 BILLION dollars in Roth IRA conversions were completed in 2010 (per the latest IRS numbers I could find).  A brief overview of the Roth IRA conversion process can be found here.

It’s pretty easy to grasp that converting a traditional IRA to a Roth IRA will generate taxable income for us.  And we can usually calculate pretty easily the tax cost now (and tax savings later) of converting our IRA’s to a Roth-style IRA.  On-line calculators, such as these (1,2 and 3) can quickly and easily do so for us.

But do we always fully understand the tax implications of the conversions?  Is it really as easy as simply multiplying our marginal tax rate by the amount of the conversion to understand our true tax cost?

Unfortunately, it’s NOT that easy for many taxpayers.

I won’t debate the “fairness” of the US income tax system, but we clearly have a progressive tax code.  This simply means that the higher your income, the higher your tax rate and the more you have to pay in income taxes.  Like it or not, they are the rules of the game.

It’s equally true that as incomes rise, the total tax due is impacted in two ways – from (1) the increase in income obviously, but also from (2) the reduction or elimination of certain deductions and credits.

Many of the most common and popular deductions and credits are phased out as your income increases, including income claimed due to Roth IRA conversions.  Also, non-income tax costs may increase as well.

Here are many deductions and tax credits that may be impacted by higher incomes due to Roth IRA conversions, although, I’m sure it’s not all inclusive!

Items directly on your tax return:

  • Child Tax Credit limitation or elimination
  • Child and Dependent Care Tax Credit limitation or elimination
  • Adoption Tax Credit limitation or elimination
  • Long-term capital gains tax rates may go from 0% to 15%, 20% or 23.8%
  • Phased out of eligibility for new tax deductible IRA contributions
  • Reductions of your itemized deductions and personal exemptions (“the Pease limitation”)
  • Alternative Minimum Tax (AMT) Exemption amount reduced
  • Higher amount of Social Security income subject to income tax
  • Earned Income Tax Credit limitation or elimination
  • Coverdell Education IRA contribution limitation or elimination
  • American Opportunity Credit limitation or elimination
  • Lifetime Learning Credit limitation or elimination
  • US Savings Bond Income Exclusion limitation or elimination
  • Student Loan Interest Deduction limitation or elimination
  • Saver’s Tax Credit limitation or elimination

Some of these items would require a significant income as the phase out begins with incomes over $300,000.  Obviously, these would impact few taxpayers.  However, many deductions and credits can be impacted with much lower income, such as the Savers Credit (phase out begins at just $18,501 in income) or the Lifetime Learning Credit (with a phase out beginning at only $55,001) (both figures are for single taxpayers).

Items NOT on your tax return that may be impacted:

  • Phased out of eligibility for new Roth IRA contributions
  • Reduction in need based college financial aid available (usually based on the “Free Application for Federal Student Aid” form, which includes your income)
  • Reduction or elimination of public assistance; for example, food stamps, energy and housing assistance
  • Affordable Care Act (i.e., ACA or “Obama-care”) subsidies may be reduced or eliminated
  • For those on Medicare, your premiums may be higher in the subsequent year

Note: There may be additional taxes and costs imposed by your state and locality due to the higher taxable income from a Roth IRA conversion.  Be sure to research and understand them as well!

It’s important to consider all of these (and possibly other!) items that may be impacted negatively if your income increases due to Roth IRA conversions.  As you can see, there is a lot more that goes into this analysis than simply looking at your marginal tax rate!

Tip:  If you self prepare your tax returns, consider using your in-home tax software to prepare a more complete analysis of the cost of a Roth conversion.  Using your previous year’s data (assuming no major tax law changes, of course), you can play a few “what-if” scenarios to see the impact on your returns.  Pay particularly close attention to any tax credits that may be reduced or eliminated, as well as deductions that are limited due to the higher income.  Of course this suggestion would only help with items actually on your returns.  It would not reflect the impact of non-return items such as lost ACA subsidies or increased Medicare premiums.

By no means am I suggesting that you not complete a Roth conversion.  Just be sure you do a complete analysis of the costs in advance so you don’t get a nasty surprise later!