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Don’t Shoot Your Conversion in the Foot with Bad Tax Planning

By: John Pitlosh

By: John Pitlosh CFP®, MST

When 2010 rolls around, more affluent families will blindly do Roth Conversions without evaluating the true cost that large amounts of additional income will have on their tax return. If you want your conversions to cost you less in upfront taxes, there are several items you will want to consider before you decide on the amount you want to convert.

State Income Taxes “ One of the biggest potential drags that most people dont factor into their conversions is the impact of state income taxes. If you live in states that have high income tax rates like New Jersey (10.75%) or California (9.55%), you will want to double check the long term math of what you are trying to accomplish before you commit to the conversions. If you live in states that dont levy an income tax like Nevada, Texas, or Florida then there will be no impact and you have a green light. If you are planning a conversion and planning to move to a state with more favorable state income tax laws, postponing your conversion could make it more tax efficient in the long run.

For Example:

A married couple living in California with taxable income of more than $92,698 in 2009 will be in the highest tax bracket at a whopping 9.55%. If you are already in the highest tax bracket and you are considering a conversion of $50,000 you just added $4,775 in taxes that you will need to overcome.

Itemized Deductions Another factor that a lot of people forget to take into consideration when converting their IRAs is the fact that their medical and miscellaneous deductions will get reduced as their income increases based on the amount that is converted. Your medical and miscellaneous deductions are only allowed beyond a specified percentage of your adjusted gross income or AGI. You also need to keep in mind that AGI is income before your itemized deductions, exemptions, and credits.

For Example:

The floor that you must go above before you can start to deduct medical expenses is 7.5%. If you have an AGI of $100,000 and you just added an additional $50,000, your threshold for deductions went from $7,500 to $11,250.

Alternative Minimum Tax (AMT) “ Outside of state income taxes, the other item that can take a big bite out of your ideal conversion is Federal AMT. AMT is the secondary tax system that was set up to “catch” high income taxpayers that werent paying their fair share of taxes into the system. The AMT tax system accomplishes this goal by eliminating or reducing certain deductions, credits, or other benefits, and then calculates the tax based on the AMT rates. The following items will impact the bottom line of your conversion.

  • The number of dependents that you claim.
  • Large itemized deductions from medical expenses.
  • Large itemized deductions due to state income or property taxes.
  • Large itemized deductions from miscellaneous expenses like investment management fees or unreimbursed business expenses.
  • The exercise of incentive stock options (ISOs).
  • Large amounts of qualified dividends and capital gains.

An individual that is looking to minimize the effects of AMT should look for ways to reduce their Adjusted Gross Income in the years that they are converting or having to pay for the conversion of their IRA. Some of the simple things you can do include:

  • Maximize 401(k) or other retirement plan contributions.
  • Realize as many capital losses as possible in a given year.
  • Maximize contributions to cafeteria plan programs like a flexible spending account or health savings account.
  • If self employed, make sure to take all business related expenses on Schedule C and not as itemized deductions.

In 2010 and beyond, more people will be looking to convert their IRAs than ever before, and since the point of doing a Roth Conversion is to take advantage of tax free growth, you should have a plan in place to help the long-term success of your conversions by minimizing the upfront taxes. The key to a successful conversion strategy is to take your conversion target and devise a plan that results in the least amount of taxes over time. The end result could be biting the bullet and doing the conversion all in one slug, or it could mean spreading it out over a period of several years. It could be tempting to make a decision by using one of the plethora of Roth conversion calculators that are available on the internet, but do yourself a favor and get some help. The majority of “conversion calculator rely on simple assumptions and not your actual tax return, so you could really miss the mark and shoot your conversion in the foot. The most practical way to navigate through your options is to work with your financial advisor or CPA and have them run some long term projections with specialized software that will take these factors into account.