Roth IRA conversions, AMT repeal, and VAT

The Washington Update from Andy Friedman

Roth IRA conversions:  Tax rates are likely to rise at year end as Washington considers whether to permit some or all of the Bush tax cuts to expire.  On the other hand, tax reform efforts in 2013 could reduce rates.  Fluctuating tax rates provide an interesting arbitrage opportunity for Roth IRA conversions in 2012.  Investors who expect to remain in the same tax bracket in retirement might wish to convert their IRA to a Roth IRA this year so that they can receive future earnings tax-free.  If tax rates then fall next year, they can act before October 2013 to re-convert back to the traditional IRA.  A new white paper on the site discusses the rules governing Roth IRA conversions (and re-conversions) and identifies the types of investors who might be well-advised to pursue this strategy.

And now to this quarter’s mailbag:

Is there a chance that Congress will repeal or ameliorate the alternative minimum tax?

The alternative minimum tax has become a chronic headache for many taxpayers.  The AMT was enacted to ensure that wealthy individuals pay their “fair share” of taxes.  Over the years, due to tax cuts and bracket creep caused by inflation, the AMT has crept very much into the middle class, affecting an ever increasing number of taxpayers.

Given outsized federal budget deficits, the government cannot afford simply to repeal the AMT and lose the significant revenue it raises.  Although this inability may frustrate affluent taxpayers, the alternative could be worse.  If Congress were to repeal the AMT, it would need to recoup the lost revenue.  It likely would do so by raising further the taxes imposed on the people the AMT was initially intended to affect — namely, the wealthy.  So affluent taxpayers may be better off with the current system, under which middle class taxpayers contribute to the revenue raised by the alternative minimum tax.

Although Congress is unlikely to repeal the AMT as a standalone “rifle shot”, there is some prospect that next year Congress will tackle tax reform — eliminating loopholes, simplifying the tax code, and reducing the top tax rates.  Part of reform likely would be the elimination of the AMT.  Whether Congress can agree on tax reform legislation in today’s partisan atmosphere is far from certain.  Absent successful tax reform legislation, the AMT is here for the foreseeable future.

Ironically, the AMT may offer affluent investors some salvation from higher tax rates.  The Bush tax cuts are slated to expire at year-end.  The Obama Administration is proposing permitting the tax cuts to expire only for families with income over $250,000 (individuals with income over $200,000).  Either way (whether the cuts expire for everyone or only affluent payers), higher-income taxpayers face the prospect of increased tax rates next year.  But many taxpayers’ alternative minimum tax will continue to exceed their regular tax, even when regular tax is computed at the new, higher rates.  These taxpayers will feel no effect from the expiration of the Bush tax cuts.  Other taxpayers will move out of the AMT position as the regular tax rates rise; that is, their regular tax computed at the new, higher rates will exceed their AMT.  Taxpayers in this position, however, are permitted to carry forward the AMT paid in prior years and offset that amount against regular taxes due.  For these taxpayers, the carryforward of prior AMT paid will blunt the effects of the tax increase.

One final point.  Every year, Congress keeps the AMT from expanding even further into the middle class by passing an “AMT patch.”  Currently, there is no patch in place for 2012.  Congress is likely to seek to enact this patch in the lame duck session at year-end or, failing that, early next year on a retroactive basis.

Are we likely to see Congress enact a value added or national sales tax?

Heightened concern about the budget deficit has led to talk of the need for a federal “consumption tax”, perhaps in the form of a value added tax (VAT) or a national sales tax.  Among other advantages, such a tax would address the revenue loss from the “underground economy” by imposing tax when unreported income is spent.

Both parties have rejected a national consumption tax, albeit for different reasons. Even small increases in the consumption tax rate would bring in billions to the federal government.  Republicans thus reject a consumption tax as a money machine that inevitably will lead to less fiscal discipline and higher government spending.

Democrats, too, have concerns about a consumption tax.  A consumption tax falls most heavily on the Democrats’ natural constituency:  middle- and lower-income taxpayers, who spend a greater portion of their income.  So Democrats do not want to tax what people spend; they want to tax what people earn that they don’t spend.  Thus Democrats want to keep the income tax and further stratify it, raising rates on the wealthy to capture some of the money they are earning but not spending.

In 2010, the Senate passed a resolution against a consumption tax by a vote of 85-13.  The Simpson Bowles deficit reduction panel viewed the enactment of a consumption tax as so politically unlikely that it did not propose such a tax in its final report.  Given this sentiment, a consumption tax is unlikely to be enacted anytime soon, regardless of which party is in power.

The Washington Update