In 2010, the law that imposed income limits on Roth conversions was changed so that anyone, regardless of income, could take advantage of them. This remains the case today, meaning that you should be aware of the rules, the benefits, and the costs.
In case you are not familiar with it, a Roth conversion involves moving assets from a Traditional IRA to a Roth IRA. The benefit is that, because Roth IRAs are tax-free instead of tax-deferred like a Traditional IRA, you never have to pay taxes on these assets again. The catch is that you must pay ordinary income tax on the conversion amount in the tax year in which it occurred.
While tax-free growth for life is a benefit any investor would want, the cost in terms of upfront income taxes can be quite daunting. For anyone with a sizable Traditional IRA, a full conversion could result in hundreds of thousands of dollars of taxes, and because the conversion is treated as ordinary income, it could also potentially push you into higher tax brackets, resulting in even higher taxes.
When it comes to Roth conversions, we encourage our clients to think small instead of big. While a full conversion may not make sense given the significant, upfront tax hit, it is worth considering smaller conversions–even if it is only a few thousand dollars—as there is no limit to how often you can convert.
We advise our clients to pay attention to any unused deductions or non-passive losses that can be used to offset conversion income. For example, if your deductions exceed your income by $10,000 in a given tax year, you could convert $10,000 worth of your Traditional IRA for free. You get the benefit of tax-free growth for life on those funds at no cost, and you use a deduction that may have otherwise gone to waste.
It also makes sense to consider converting smaller amounts at the lower end of the tax bracket. For example, in 2012 the 15% Federal tax bracket for married filers ranges from $17,400 to $70,700 of taxable income. So, if your taxable income is $60,000 this year, you could convert $10,000 worth of your Traditional IRA for a low cost. This would make sense if you expect your income (or tax rates) to go up in the future.
Look to increase your tax-free asset base by taking advantage of potential “no cost” or “low cost” conversions, even if it is in small amounts each year. Over time, those conversions can add up. However, it is important to remember that a conversion can increase taxes on your Social Security, affect your Medicare Part B premium, and subject you to the alternative minimum tax. So it is important to consult your tax advisor before proceeding with a conversion.