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No-Pain Roth Conversion

No-Pain Roth Conversions

Funding a Roth IRA is far from simple. You (or your spouse) must have earned income in order to make a contribution. If your income earned and unearned is over $129,000 this year ($191,000 for couples filing joint tax returns), you can’t contribute anything to a Roth IRA. And even if you pass those screens, the most you can contribute is only $5,500 (or $6,500 if you’re 50 or older).


That’s for contributions. On the other hand, the sky’s the limit for Roth IRA conversions. You can convert any amount from a traditional IRA to a Roth IRA. (Note that “traditional” IRAs also include Rollover, Spousal, SEP, and SIMPLE IRAs, or any IRA format that, unlike the Roth, deferred taxation when the contributions were made.) You don’t need any earned income for a conversion and there’s no income limit. No matter how much income you report, you still can convert all or part of a traditional IRA to a Roth IRA.


One strategy would be to put your $5,500 or $6,500 into a traditional IRA, which has no income limit, and then convert it. You can do so, but like all conversions from a traditional IRA to a Roth, any pretax dollars you move from your traditional IRA to your Roth IRA will be added to your taxable income in the year the conversion is made. Not only will you owe tax at your marginal rate, you might move into higher brackets and possibly trip some of the tax traps in the code..

 

Tax Traps

 

It’s no wonder that many people are reluctant to convert their traditional IRAs to Roths. While the long-term benefit is appealing, the short-term costs could be significant. To see what might happen consider a couple who have taxable income (after deductions) of $125,000. That puts them in the 25% federal income tax bracket, which runs from $73,801 up to $148,850 of Adjusted Gross Income (AGI) this year.


Suppose that one spouse rolled her 401(k) account into a traditional IRA tax-free and suppose that her IRA has grown to $300,000. If she converts her entire traditional IRA to a Roth IRA, she’ll report an extra $300,000 of taxable income, which would bring their taxable income to $425,000. This couple would have moved from a 25% tax bracket all the way through the 28% and 33% brackets and into the 35% bracket (which starts at an AGI of $405,101).


Altogether, they’d owe an extra $93,590 to the IRS, reducing the $300,000 potentially tax-free retirement account to just $206,410, unless they paid the tax from other (external) sources. The couple would also be likely to incur a hefty amount of state taxes on the conversion.


In fact, that extra $300,000 could be even more costly. With $425,000 in taxable income, they would be over the threshold for the 3.8% surtax on investment income. What’s more, at that level of income, there is a “phase-out” of itemized deductions, which could increase their taxable income further.

 

Partial Conversions

 

Roth IRA conversions don’t have to be all-or-nothing. Regular (or even irregular) annual partial conversions in amounts designed to “fill up” your tax bracket may be the best answer.


In the example I mentioned above, a $23,850 conversion from the traditional IRA to a Roth IRA would raise the taxable income from $125,000 to $148,850, which is still within the 25% tax bracket for 2014. This would be an efficient way to build up a tax-free (rather than tax-deferred) retirement income account.


You could make a series of partial conversions, gradually reducing your traditional IRA. A large traditional IRA can become a liability once you are past 70-1/2 years of age because of the required minimum distribution (RMD). You must make annual withdrawals of a percentage of the assets in the account based on your life expectancy. These withdrawals will add to your taxable income and possibly affect your marginal tax rate. By establishing a strategy of regular conversions from your traditional IRA to fund your Roth, you would be reducing your future RMDs, while growing your tax-free Roth IRA with relatively little tax pain each year.

 

Rear-view Tax Planning

 

This strategy should be easy to follow for people who can anticipate their taxable income for the next 10 or 15 years. But how will it work if your taxable income fluctuates from year to year? It can work very well. There’s a feature of the Roth IRA that allows taxpayers until October 15 of the following year to “re-characterize” (reverse) the conversion. This gives you a rare chance at rear-view tax planning. If your conversion will put you in a higher tax bracket, you can reverse all or part of the Roth IRA conversion back to a traditional IRA.


For example, say you convert $100,000 of your traditional IRA to a Roth IRA by year-end 2014. By October 15, 2015, a stock market correction reduces your Roth IRA to $80,000 and you don’t want to pay tax on a $100,000 conversion when the account is now only worth $80,000. Naturally, you'd prefer to pay the tax on the lower amount. In that case, you may want to re-characterize the conversion and avoid a tax bill altogether for this year. Remember, though, that you'd have had to pay the tax on the full conversion if you filed your return by April 15, so you’d need to file an amended return to get the tax money back following re-characterization. (That wouldn’t be the case if you had requested a filing extension until October 15.)


Thinking in a different direction, suppose your Roth IRA is still worth $100,000 the following year. However, when you prepare your 2014 tax return you see that your taxable income would be $194,000, without adding any income from the Roth IRA conversion.


In this scenario, you would be in the 28% tax bracket, which goes up to $226,850 on a joint return this year. You may decide that you prefer to convert only $32,850 from the Roth IRA conversion, which would “fill up” that 28% bracket. You would therefore re-characterize $67,150 (the $100,000 minus the $32,850) and pay tax on a $32,850 Roth IRA conversion, recouping any excess tax payment with an amended return.


Investing Your Roth in Great Stocks

 

I’ve stressed this Roth conversion strategy over the years in the issues of Moneypaper. Since no one knows what the tax rates will be when it is time to retire, it's smart to utilize such tactics to accumulate a pool of funds in your Roth IRA. You’ll minimize the tax over the years, and in retirement, you can drain your Roth as slowly or as fast as you wish, without sharing further with the IRS.


The trick is to invest your tax-free Roth IRA in great stocks. The better your stock picking, the more tax-free income you’ll ultimately pull from it.


In 1999, The Moneypaper established the MP 63 Fund (DRIPX) at the request of subscribers who wanted to build holdings in their IRAs by investing based on a dividend reinvestment plan (DRIP) strategy. The 63 companies included in the fund’s portfolio, as well as its performance results can be viewed at DRIPX.com.


Both David Fish, my co-manager, and I have our Roth IRAs invested in the MP 63 Fund and all six of my grandchildren’s Roth IRAs are invested in the fund as well. By the way, early withdrawals (before the age of 59-1/2) from all IRAs may be subject to a 10% penalty. However, that penalty is waived for certain exceptions, such as withdrawals used for qualified higer educational purposes. You’ll still owe regular income tax on withdrawn profits before the IRA has been open for 5 years and age 59 1/2. But, if the student is the account owner, the regular tax might be little or nothing.


How did my grandkids qualify for Roth IRAs at their tender ages? That will be the subject of a future article.