Roth IRA Conversion: Tax-Smart Money Move Surges in Popularity

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Five years ago, many Americans watched their retirement savings get crushed by the stock market's meltdown in the wake of the financial crisis. Now that stocks have come back, most investors are faring a whole lot better, and it's showing up in their average retirement account balances.

But one even more encouraging sign is that many investors are taking a key step toward shoring up their retirement finances in a tax-smart way.

The Skinny on Saving for Retirement

Fidelity Investments reported on Wednesday that the average balance across the 7 million individual retirement accounts it oversees hit $81,100 as of the end of 2012 -- its highest level in five years.

More impressively, that balance represents a 53 percent jump from the average balance at the end of 2008, and age groups in or near retirement saw even greater gains of 70 percent to 81 percent from 2008 levels. Average IRA contributions were up 3.1 percent over the past year, and that combined with the market's strong performance have pushed balances up.

But the most surprising news from the Fidelity report was the big surge in Roth IRA conversions at the end of 2012. Fidelity reported 52 percent more Roth conversions in the last month of 2012 than it saw in December 2011. Overall for the year, conversions rose 12 percent.

Why Converting Was Smart

The move toward Roth conversions is consistent with some other tax strategies that gained popularity at the end of last year.

With tax rates scheduled to rise at the beginning of 2013, taxpayers found themselves in the unusual position of wanting to increase their taxable income for 2012, taking the hit while rates were low in order to avoid a bigger tax bill in future years.

Roth conversions provided an easy way for taxpayers to accomplish that goal and lock in tax savings for the rest of their lives.

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Under the rules governing Roth conversions, the money you convert gets counted as taxable income for the year of the conversion. But once it's in the Roth, you don't have to pay taxes on the income or gains from investments within the account, even when you take withdrawals during retirement.

Roth conversions have been an option for 15 years, but the appeal dramatically expanded in 2010, when previous income limits on conversions disappeared. Yet during normal tax years, accelerating income didn't make as much sense as it did last year, and so taxpayers haven't always taken full advantage of the Roth opportunity.

Should You Convert?

The most important consideration in deciding whether to convert to a Roth is whether your current tax rate is higher or lower than the taxes you'll pay in retirement.

If you're in a very low bracket now, converting essentially lets you lock in your current tax rates, so you avoid having to pay potentially higher taxes after you retire.

By contrast, if you're in a top bracket, then it becomes much more of a gamble on future rates, as you're betting that paying more than 40 percent in taxes now will be a better deal than what you'll pay in retirement when you take withdrawals from a traditional retirement account.

Another factor, though, is whether you have money outside your retirement account to pay the extra taxes you'll incur. Taking money out of your IRA to pay those taxes makes converting much less attractive, as it incurs a 10 percent penalty and reduces the long-term benefits of the conversion.

It Might Not Be Too Late

With tax rates now at higher levels for many taxpayers, the Roth conversion opportunity that presented itself late last year is now over. But that doesn't mean converting is a bad idea.

To see whether you should convert, run your own numbers and figure out whether the long-term advantages outweigh the potential costs.

Roth IRA Conversion: Tax-Smart Money Move Surges in Popularity

Craig says that perhaps the biggest mistake is trying to find someone who will give you the largest refund without making sure that it's accurate. "I got a guy last year who came in at the very last minute on April 10," says Craig. "He and his wife filed separately to take more exemptions, and the tax preparer he'd initially used was really aggressive about reimbursing. The guy was flabbergasted by how much he still owed and came to me 'refund shopping' to see if I could lower his tax liability, and I had to tell him, 'You actually owe more,' because the other preparer was so aggressive with the deductions."

If your tax preparer is confident in the accuracy of the return that he's prepared for you, then he'll have no trouble putting his name on it. But if he doesn't sign the return, it could be a sign that he's done something shady. In fact, Craig says, "If [the mistakes on your return are] serious and seem intentional, you can report him to the IRS. That's grounds for losing one's license."

This mistake has an easy solution: In addition to keeping those receipts for unreimbursed business expenses, always keep a record of your company's reimbursement policy -- even for past years. This is the only document that will save you in an audit. Without it, the IRS won't recognize those expenses.

If you're not a real estate professional, and you make more than $150,000, you can't take losses on any rental properties that you own against your normal working wages in order to lower your taxable income. Take it from Craig: "I had a client making $300,000, and taking $160,000 in real estate losses" -- none of which was allowed. His bill? A cool $50,000 in back taxes and penalties.

"This has been really popular the last few years," says Craig, "but IRS regulations around that have become more stringent in terms of documenting the value. If you've got a 1985 Toyota Corolla sitting in your garage, and you donate that vehicle to charity, claiming it's worth $1,500, you'd better have good documentation to support that value." His recommendation: Start with the Kelley Blue Book value. And if you make any improvements to the car, keep the receipts so you can prove their worth.

This year, the IRS changed the requirements on the home office deduction for the 2013 tax year (to be filed in 2014). Under the new rule, taxpayers have the option to take a "standard" home office deduction of $5 for every square foot of office space up to 300 square feet. In the interim, the home office deduction could trip up those filing for it in the 2012 tax year, so make sure to measure your square footage correctly.

Let's say you buy a few shares of Facebook stock, and then you later sell them at a small loss. Normally, you could deduct that loss against any other capital gains you made that year in order to lower your taxes. But if you buy the stock back within 60 days of selling, then the first sale is disregarded. "It's like you never sold the stock in the first place," says Craig. And you won't get the tax benefit.

Here's a "mistake" that you can retroactively use to lower your taxes in the previous year. Plus, it also boosts your retirement savings! If you have a 401(k) at work, you can also contribute to your retirement savings in a traditional IRA and get a tax deduction if your income falls under the income limits. (For 2012, singles making $58,000 or below and those married filing jointly making $92,000 or below can contribute the full $5,000 to their IRAs; singles with income between $58,000 and $68,000 and married couples with income between $92,000 and $112,000 can make partial contributions.) So let's say that it's 2013, and you realize that you didn't contribute the full amount allowed to you for your IRA for 2012. You can still make a contribution now that will count for 2012, lowering your taxes for that year.

Although things that happen in your family life or your job may seem unrelated to your taxes -- and therefore none of your CPA's business -- they can affect how much you owe. "Maybe your mother has moved in and is dependent on you, or your kids are now old enough to be in daycare," says Craig. "Tell your CPA what's going on in your life instead of just bringing him a bundle of forms." For instance, if you've changed jobs, your CPA could help you structure your compensation to maximize tax savings.

"Find a tax preparer who knows and cares about what makes you you," says Craig. Your CPA should know what brings you pleasure in life, what kind of family you have and what your values are. This way, for instance, he or she can help you make sure you're meeting your retirement goals with smart tax planning. Also, according to Craig, "the CPA can look out for opportunities to bring you during the year."

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