Long ago, there wasn't much that planners had to worry about as far as taxes except for lawmakers changing tax law. Now we have to worry that, if Congress does nothing, taxes will jump in 2013. In these financially tumultuous times, Roth conversion strategies can reduce risk substantially for clients in 2012.

UNKNOWNS FOR 2013

Regardless of whether Republicans or Democrats prevail in controlling the White House and/or Congress in November, there is likely to be an impact on tax law. If nothing is done, the Bush-era tax cuts will expire and the highest federal individual income tax rate will increase to 42%, taking into account deduction phaseout. On top of that, if the federal health care overhaul survives legal challenges, an additional 3.8% Medicare surcharge on investment income for those earning more than $200,000 ($250,000 for joint returns) will take effect.

As if the political uncertainty weren't enough, the wild swings in the stock market and other investments create further uncertainty. Will the euro survive? Might there be a major natural disaster? One way of planning for these uncertainties is to predict the outcome and prepare for it. Unfortunately, predictions of market strategists have proved to be very inaccurate. A much better way is to admit we don't know the future and plan as such, giving as much flexibility as possible to our clients. Enter the Roth conversion.

TRADITIONAL VS. ROTH

Gregg Polsky, a tax professor at the University of North Carolina School of Law, suggests we view a traditional IRA as a partnership between the taxpayer and the government. If the client has a $100,000 traditional IRA (with a zero basis if it was funded with pretax dollars) and is in the 35% marginal tax bracket, the taxpayer owns $65,000 while the government (federal and state) owns $35,000. The IRA is a partnership between the taxpayer and the government. Admittedly, the ultimate tax bracket upon withdrawing the funds from the traditional IRA is unknown.

Polsky notes that, if the taxpayer decides to convert this IRA to a Roth IRA, he or she is buying out the governments' ownership in the partnership and can then keep all of the returns tax-free going forward. At least this is true without a major change in the tax law. If the client does a Roth conversion in early 2012 with some or all of their traditional IRA funds, he or she has as late as Oct. 15, 2013 (if they file an extension on their 2012 return) to recharacterize some or all of the conversion.

Polsky refers to this recharacterization as a free put option. By exercising the put option, the taxpayer requires the government to buy back its original share of the IRA for the purchase price the taxpayer paid. I liken it to the undo key on a computer. It is this put option that can be so valuable in hedging political and market uncertainty.

John Bledsoe, author of The Gospel of Roth: The Good News About Roth IRA Conversions and How They Can Make You Money, recommends that everyone should convert 100% of his or her IRAs to Roth IRAs as early in the year as possible. Robert Keebler, a partner at Keebler & Associates, a tax and estate planning firm in Green Bay, Wis., agrees. Both specialize in assisting clients to carry out Roth conversion strategies.

They each note that a lot can happen between Jan. 1, 2012, and Oct. 15, 2013. If clients go into the conversion with the premise that they may recharacterize, they in essence get a free look and can keep any conversions that make sense. "Why wouldn't anyone want this free look?" Bledsoe asks.

HEDGING STRATEGIES

Here are three strategies for hedging future uncertainties:

1. Simple hedging against 2013 tax increases and market declines. This is the simplest and most straightforward of the strategies. To protect against potential tax increases and even a market decline, the client can convert that $100,000 and pay $35,000 to the IRS. If it turns out that tax rates did increase, the client could save up to 10% by converting in 2012 instead of waiting.

If rates didn't increase, then a recharacterization may be in order. But Keebler believes a 2013 income tax increase is likely, although he sees the Medicare surcharge in the hands of the Supreme Court.

The second reason a client may want to recharacterize is if the market has a significant decline. Say the $100,000 portfolio declined to $80,000 sometime before 2012 taxes are filed in 2013. Rather than take the whole $20,000 loss, hit the undo button and recharacterize, and the government will take 35% of the loss. In this case, even if tax rates did decrease, the gain from the government taking on a share of the loss is larger than the hit from the tax increase. Both must be taken into account in the decision to recharacterize.