Optimizing Your Roth IRA Conversions.
The law allows you to convert some or all of your traditional IRA funds to a Roth. In doing so, you agree to effectively reverse any prior benefits you received from deducting your contributions to traditional IRAs by being taxed currently on the amount of the conversion in exchange for receiving tax-free distributions once you turn 59 ½. Normally, the earlier in your career that you convert, the better; but first, let’s discuss some IRA basics.
In general, contributions to a traditional IRA may be wholly or partially tax deductible. You pay no tax on the earnings or growth in the funds, but distributions are taxed as ordinary income at rates of up to 39.6%. You must begin taking required minimum distributions (RMDs) from your traditional IRAs no later than the year following that in which you turn 70 ½.
Roth contributions, on the other hand, are never deductible. A taxpayer can withdraw his or her Roth contributions at any time without tax or penalty but must wait five years from the original contribution date (or date of Roth conversion) and be over 59 ½ in order to qualify distributions of Roth IRA earnings as tax-free. While there are exceptions, they are not the focus of this discussion. Roth IRAs are exempt from the RMD rules during your lifetime.
A Roth conversion is available to everyone regardless of AGI and is taxed as ordinary income in the year of conversion. You can convert all or part of a traditional IRA each year. When and how much you convert depends on such variables as the size of the account to be converted, your tax brackets now and expected in retirement, whether you have funds available outside of the IRA fund to pay the current tax and if you need to take RMDs in retirement.
The normal rule of thumb is to convert up to the amount that will knock you into the next tax bracket. The earlier in life that you do this the better since your investments will have more time to grow tax-free. For example, a joint filer who is in his thirties and in the 25% tax bracket who expects $160,000 of joint taxable income can make a 2016 conversion of up to $71,450 before reaching the $231,450 threshold of the 28% tax bracket. While federal taxes of $17,863 would be due in 2016, at a nominal growth rate of 4%, the value of that investment could triple by retirement and be completely tax-free upon distribution.
Practically speaking, you will not yet know your current year income when you execute the conversion. You may, however, “recharacterize” any excess back into a traditional IRA up until the due date of the current year tax return (including extension). This would mean that you have until October 16, 2017, to recharacterize all or part of a 2016 conversion. Referring to the previous example, assume that actual taxable income is $175,000. To avoid having the additional $15,000 taxed at 28%; it can instead be recharacterized to a traditional IRA.
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