Recently the IRS released 2013 cost-of-living adjustments related to retirement plans. The adjustments can enhance your ability to benefit from IRAs and qualified retirement plans such as 401(k) plans and defined benefit plans. But some limits aren’t going up, and most of those that are going up are doing so by modest amounts. While maxing out your retirement plan contributions is almost always a good idea, your biggest retirement planning opportunity may be a 2012 Roth IRA conversion.
Slight increases to many limits
Most — but not all — retirement-plan-related limits will go up in 2013, potentially providing slightly enhanced opportunities to build retirement savings:
Phaseout ranges expand opportunities
Your modified adjusted gross income (MAGI) may reduce or even eliminate your ability to take advantage of IRAs. Fortunately, IRA-related MAGI phaseout range limits all will increase for 2013:
Traditional IRAs. MAGI phaseout ranges apply to the deductibility of contributions if the taxpayer (or his or her spouse) participates in an employer-sponsored retirement plan:
• For married taxpayers filing jointly, the phaseout range is specific to each spouse based on whether he or she is a participant in an employer-sponsored plan:
o For a spouse who participates, the 2013 phaseout range limits increase by $3,000, to $95,000–$115,000.
o For a spouse who doesn’t participate, the 2013 phaseout range limits increase by $5,000, to $178,000–$188,000.
• For single and head-of-household taxpayers participating in an employer-sponsored plan, the 2013 phaseout range limits increase by $1,000, to $59,000–$69,000.
Taxpayers with MAGIs within the applicable range can deduct a partial contribution; those with MAGIs exceeding the applicable range can’t deduct any IRA contribution.
But a taxpayer whose deduction is reduced or eliminated can make nondeductible traditional IRA contributions. The $5,500 contribution limit (plus $1,000 catch-up if applicable and reduced by any Roth IRA contributions) still applies. Nondeductible traditional IRA contributions may be beneficial if your MAGI is also too high for you to contribute (or fully contribute) to a Roth IRA.
Roth IRAs. Whether you participate in an employer-sponsored plan doesn’t affect your ability to contribute to a Roth IRA, but MAGI limits may reduce or eliminate your ability to contribute:
• For married taxpayers filing jointly, the 2013 phaseout range limits increase by $5,000, to $178,000–$188,000.
• For single and head-of-household taxpayers, the 2013 phaseout range limits increase by $2,000, to $112,000–$127,000.
You can make a partial contribution if your MAGI falls within the applicable range, but no contribution if it exceeds the top of the range.
(Note: Married taxpayers filing separately may be subject to much lower phaseout ranges for both traditional and Roth IRAs.)
2012 Roth IRA conversions especially attractive
As you can see, your ability to benefit from tax-advantaged retirement accounts is constrained by various statutory limits, especially if your income is high. If you have a traditional IRA, converting all or a portion of it to a Roth IRA might be your biggest retirement planning opportunity.
A conversion can allow you to turn tax-deferred future growth into tax-free growth. It also can provide estate planning advantages: Roth IRAs don’t require you to take distributions during your life, so you can let the entire balance grow tax-free over your lifetime for the benefit of your heirs. If your MAGI is high, a conversion may be the only way you can take advantage of a Roth IRA’s benefits.
The downside of a conversion is that the converted amount is taxable in the year of the conversion. But there are a couple of reasons why 2012 may be an especially good year to make the conversion and take the tax hit:
1. Saving income taxes. Federal income tax rates are scheduled to increase for 2013 and beyond unless Congress extends current rates or passes other rate changes. So if you convert before year end, you’re assured of paying today’s relatively low rates on the conversion. In addition, you’ll avoid the risk of higher future tax rates on all postconversion growth in your new Roth account, because qualified Roth IRA withdrawals are income-tax-free.
2. Saving Medicare taxes. If you convert in 2012, you don’t have to worry about the extra income from a future conversion causing you to be hit with the new 3.8% Medicare tax on investment income, which is scheduled to take effect in 2013 under the healthcare act. While the income from a 2013 (or later) conversion wouldn’t be subject to the tax, it would raise your MAGI, which could cause some or all of your investment income in the year of conversion to be hit with the Medicare tax.
Likewise, you won’t have to worry about future qualified Roth IRA distributions increasing your MAGI to the extent that it would trigger or increase Medicare tax on your investment income, because such distributions aren’t included in MAGI. While traditional IRA distributions won’t be subject to the Medicare tax, they will be included in MAGI and thus could trigger or increase the Medicare tax on investment income.
Determining the best course of action
The 2013 increases to many retirement-plan-related limits may allow you to boost your tax-advantaged savings next year. If you’re looking for additional opportunities, consider a Roth IRA conversion before year end.
But also keep an eye on Congress. It’s possible that current income tax rates could be extended or the healthcare act Medicare tax provisions could be repealed (making a 2012 conversion less compelling). The good news is that you can undo a Roth conversion, as rates could even be reduced in 2013, making a 2012 conversion costly.
If you’d like to learn more about retirement planning, Roth IRA conversions or the potential impact of tax law changes on your situation, please contact us. We’d be pleased to assist you in determining the best course of action.