Lately, the attention paid to Roth IRA conversions has many investors asking themselves — and their advisors — if they should convert their Traditional IRAs. However, it may be wiser to consider how much to convert. People often think of a Roth IRA conversion as an all-or-nothing endeavor. In reality, you have the option to make a partial conversion instead of a full one, which can be a practical approach to limiting your conversion tax liability.
Full vs. partial Roth IRA conversions
When you make a full conversion of a Traditional to a Roth IRA, ordinary income taxes are due on the total amount converted in that tax year. This can be a significant amount, especially if you're in a higher tax bracket or you've accumulated considerable savings over time. Plus, the additional conversion income could boost your reportable income to the next tax bracket. If the tax bill on a total conversion is too large, think about converting only a portion of your retirement assets. Partial Roth IRA conversions allow you to choose how much to convert to keep your tax obligation in your comfort zone.
Control your tax liability
A partial conversion helps ensure that your taxable income stays within your current tax bracket. Your tax advisor can help you determine the optimal partial conversion amount based on your income. Consider this hypothetical example:1
- Joe's annual taxable income equals $75,000.
- Income falls in the 25% tax bracket for 2013.
- Tax bracket tops off at $87,850.
- Joe owns a Traditional IRA worth $20,000.
Keep your conversion affordable
A partial conversion also lets you decide how much of your Traditional IRA balance to convert, based on your available cash to pay income taxes on the taxable amount converted. If you have a limited amount of money in a separate taxable account to pay your conversion taxes, you may choose to convert only the amount for which your savings will cover those taxes. This is especially important if you are under age 59½, since paying taxes with non-IRA money will not trigger the 10% IRS early withdrawal penalty. Keep in mind, your converted Roth IRA earnings can grow tax-free, and earnings can be withdrawn tax-free if you hold the conversion contribution for at least five years and you are age 59½ or older. Earnings can also be withdrawn tax and penalty free if they meet one of the other qualified distribution requirements (death, disability and qualified first time homebuyer expenses (up to $10,000 limit)) and were held for at least five years. Ideally, to help keep your retirement assets on track with future income goals, you should avoid using your Traditional IRA to pay conversion taxes.
Recharacterizations also help minimize taxes
It may sound intimidating, but recharacterization can be a valuable tax planning tool. The recharacterization process enables you to undo a full or partial conversion and revert back to a Traditional IRA, thereby negating your conversion tax bill. For example, if you converted $50,000 in January 2013, and the market value of your Roth IRA declined to $25,000 by December, you'd still owe taxes on the original $50,000 conversion at tax time. To avoid paying that hefty tax bill on an account that's lost half of its value, you can recharacterize by Oct. 15, 2014, and no longer owe conversion taxes.2 This strategy can benefit investors who wish to convert smaller sums separately, oversee market results and recharacterize any underperforming accounts. Separate Roth IRA accounts may be recommended for ease in tracking individual performance and keeping Roth IRA conversions separate from new contributions.
Learn more from your financial and tax advisors
There are many tax-related considerations when it comes to making a partial conversion. It's essential to develop a game plan based on your individual circumstances with your tax and financial professionals.