In a few short months the perfect storm will descend upon Washington D.C. that could very well send us back into a deep recession: The 2013 “fiscal cliff.”
What’s a Fiscal Cliff?
This toxic recipe includes the repeal of the Bush-era tax cuts and payroll tax cuts, a suffocating debt load, and spending reductions, combined with the need to raise the debt ceiling all coming to a head by year end. Since there’s little evidence to prove the contrary, I fully expect the fiscal cliff to go unresolved thanks to political gridlock. Many investors (and small business owners), frightened by the specter of the fiscal cliff are sitting on the sidelines in cash with a wait-and-see mentality. While I see where they’re coming from I’m generally not a fan of letting others determine my destiny—I would like to be the one in control.
One Strategy to Put You Back in Control
Under current law, the Bush-era tax cuts are set to be repealed in 2013, propelling tax rates skyward at the worst possible time. Smart investors know that there are always two sides of a trade and while higher taxes could prove to be disastrous they also offer an opportunity; ultra-low tax rates for the next few months.
Wouldn’t it be wise to consider paying income tax on some of your money now while tax rates are so low? That’s exactly what a Roth conversion can do for you, convert tax-infested accounts into tax-free accounts.
Many IRA and 401(k) owners often wonder how much they should convert to Roth. The short and simple answer is to run different hypothetical tax returns and see what the impact is on the total tax owed. It’s important to at least fully maximize your tax bracket. For example, if you’re in the 15 percent tax bracket you should at least convert up to the top of your income bracket (for married filing joint that would be up to $69,000 of income in the 15 percent bracket and $139,351 in the 25 percent bracket).
What If They Solve the Fiscal Cliff?
If the U.S. is somehow pulled back from the edge of the fiscal cliff (or more likely a delay of the inevitable) the allure of the Roth conversion is not diminished. Probably the best feature of a Roth conversion is the ability to request a “do-over.” This “do-over” feature, called a Roth recharacterization, allows you to change your mind long after the fact and reverse the Roth conversion (you have until October 15 of the following year the conversion was made). It’s like betting on a horse race after it’s over! You can convert now with the expectation of taxes rising in 2013. If they remain low you can always reverse the conversion and put everything back the way it was.
Whether tax rates skyrocket in 2013 or not, one thing’s for sure—they will eventually. It’s important to have a plan to lock in today’s low tax rates, and keep the government’s hand away from your pocket.
Robert Russell is the author of Retirement Held Hostage, CEO & CIO of the Ohio-based Russell & Company, a private wealth management firm specializing in helping affluent individuals ages 45 and up create and preserve their wealth. He co-hosts a radio show, authors The Rob Report blog, and is a frequent contributor to The Wall Street Journal, SmartMoney, & FOX Business.