Tom Martin

[Editor's Note:  This is a guest post from Tom Martin, CFP®, CPWA®, AIF® and Andrew Parker.  They work for Larson Financial Group, LLC, a physician-focused financial advisory firm with numerous branches across the country.  We have no financial relationship, although you may recall the review I did of Tom's book, Doctors Eyes Only a few months ago.   Like all posts on this site, this information is for educational and entertainment purposes only, NOT TAX ADVICE.  Neither I nor the guest posters are responsible for the consequences, financial or otherwise, of your actions based on information you read here.]

With December 31st right around the corner, now is the time to consider some important year-end tax moves.  These two potentially tax-saving strategies could help reduce thousands of dollars in unnecessary future taxes.

Andy Parker

Strategy #1 – Use your AMT tax exposure to lower your Roth IRA conversion tax rate

If, like many physicians, you find yourself regularly having to pay Alternative Minimum Tax, this may present you with an opportunity to convert your Traditional IRA to a Roth IRA (or a portion of it) at a lower tax rate of 26% or 28% instead of a future potential tax rate of 40%+.

Doesn't Apply If You Don't Pay AMT

To check your own situation, check line 45 [AMT Tax line- ed] on your 2011 Federal 1040.  If you have an amount greater than $0, this strategy may apply.  If not, and little has changed for your taxes from last year to this year, don’t waste your time with this strategy.

Presently many physicians fall into either the 33% or 35% marginal tax bracket.  That means on the next dollar of income you earn, you would owe this percentage in taxes.   A conversion from a traditional IRA (funded with pre-tax dollars) to a Roth IRA is normally taxed at your marginal income rate. However, if you are being hit with AMT, your marginal rate is actually the 26-28% AMT rate, instead of the higher 33-35% rate.  It's important to understand the difference between effective and marginal tax rates when contemplating any Roth conversion, of course.

The Strategy

If you are being hit with AMT, when you convert your traditional IRA to a Roth IRA, as long as the dollar amount on the AMT line of your tax return remains positive, you are actually paying 28% or less on the conversion, regardless of your marginal tax rate.

How to do it:

  1. Have your CPA or tax program run a proactive projection of what your 2012 tax return should look like.
  2. If you find yourself with anything on the AMT line (line 45 for 2011 but could change for 2012), have your CPA or the program build in an IRA conversion.
  3. If the amount in the AMT line goes to $0, you have converted too much, and part of your conversion is being hit with your marginal tax rate instead of the lower AMT rate.  Note: This isn’t always a bad thing, but the analysis on whether a non-AMT Roth conversion makes sense or not is beyond the scope of this post.
  4. If this happens, rerun it with a smaller conversion amount.  Keep doing this until you get a value in line 45 greater than $0.  This will show that you are paying the lower AMT rate (maximum of 28% on your conversion).

With marginal rates probably rising in January, [Congress is wrangling over the “fiscal cliff” as this is written-ed] this could save you as much as 12% in Federal tax on your IRA conversion.  Remember that after converting, the funds in the Roth IRA should grow on a tax-free basis moving forward, and you should be able to pull these funds out tax-free for retirement, provided you follow the IRS guidelines.  Learn more about the AMT in our upcoming post.

Some Criticisms/Caveats – An Editorial Note

A few criticisms of this technique are appropriately inserted at this point.  First, if you're doing Backdoor Roth IRAs  each year, you've already gotten rid of your traditional IRAs by either rolling them into a 401K or converting them (at whatever rate.)  If you still haven't converted them, you might save a little on the conversion if you would otherwise pay AMT, but that benefit is probably far smaller than enabling yourself to do Backdoor Roth IRAs going forward.

Second, you should always question the wisdom of converting at such a high rate.  While converting at 26-28% is better than converting at 35% (or more), there is a decent chance you'll have the opportunity to convert later at a lower rate, perhaps during a sabbatical, during a period of disability or lower earnings, or during the first few years of an early retirement.

Last, “locking in” a conversion at a rate likely to be much higher than your effective rate in retirement might not turn out to be wise.  Remember that a retired couple taking the standard deviation doesn't even hit the marginal tax rate (much less the effective tax rate) of 28% until they have $143K+ of taxable income. Obviously, the more you make and the more income you expect in retirement, the better this technique will be for you.  This could be a very good idea for a two-physician family with a gross income of $600K+ and planning on retirement income of $200K+.

Would you consider using this technique?  Comment below!