The $100,000 income limitation to qualify for a Roth IRA conversion has been lifted. And the government, for this year only, is allowing taxpayers to pay the conversion taxes pro rata over two years, 2011-12.
That sounds great on the surface. Who wouldn't want to pay the taxes later rather than sooner?
But one group in particular should absolutely not take the government up on their deferral offer: taxpayers in the highest federal tax bracket who expect to remain there over the next two years. They should pay the bill in full for tax year 2010.
I ran a simple projection to quantify how much extra it would cost a high-tax-bracket individual to defer their conversion taxes. I assumed a married couple living in New Jersey with no kids, earning $750,000 a year and with a sole itemized deduction of state income taxes. The hypothetical couple would be in the 35% federal marginal tax bracket and 9% New Jersey marginal tax bracket.
Converting $100,000 to a Roth IRA, the incremental federal and state taxes due -- if paid this year -- would be $40,831. If the couple instead deferred the conversion taxes over 2011-12, the total tax bill would be $46,206, primarily due to the top federal tax bracket increasing to 39.6% from 35% as the Bush tax cuts sunset next year. (A decision still at the mercy of the midterm elections.)
If the couple does defer, they can of course invest the conversion taxes until they are due. Unfortunately the difference of $5,375 won't be easy to earn, as it would require the couple to make a return of 8.6% per year after tax to break even.
I don't know about you, but I am not aware of any risk-free investments paying a rate of return anywhere near that level these days.
The bottom line for people in the top tax bracket: Uncle Sam is offering you a loan with an interest rate far higher than what you are likely to earn on a risk-free basis. My advice for taxpayers in the highest tax bracket converting to Roth IRAs this year is to bite the bullet and pay the taxes now rather than later.
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Michael Maye is the founder and president of MJM Financial Advisors, a registered investment advisory firm in Berkeley Heights, N.J. He is a member of the National Association of Personal Financial Advisors (NAPFA) and has been a speaker covering tax topics at NAPFA's national and regional conferences. Maye has also been a frequent contributor to the Star Ledger of New Jersey's 'Biz Brain' and 'Get With the Plan' articles. In addition to NAPFA, he is a member of Financial Planning Association, American Institute of Certified Public Accountants, New Jersey State Society of CPAs and the Estate Planning Council of Northern New Jersey.