2016: A Good Year to Convert IRAs?

This could be the best year in a while to maximize the benefits of converting a traditional IRA to a Roth IRA. Even if it didn’t seem to make sense in the past, it might in 2016.

You know the benefits of a Roth IRA. There are no income taxes on the IRA’s earnings or on most distributions. The original owner doesn’t have to take required minimum distributions (RMDs), and a beneficiary who inherits can take RMDs over his or her life expectancy.

The trade off is that you don’t receive any upfront tax benefits, such as a deduction for contributions. Roth IRA use is limited because many people don’t want to make contributions of after-tax dollars or their incomes are too high to qualify for Roth IRA contributions.

You know you can convert a traditional IRA (or a 401(k) account) to a Roth account. The cost of a conversion is that the converted amount must be included in gross income as though it were a distribution. You have to pay income taxes on it today, and then you won’t have to pay taxes on the future compounded gains and income.

The negative markets that have prevailed so far in 2016 are what make this a good time to consider converting a traditional IRA to a Roth. You could be converting at a discount.

Investments in stocks, commodities, and some other assets lost value so far this year. You can convert them to a Roth IRA and pay lower taxes than only a few months ago or even longer. A simple recovery to the value they had at the end of 2015 would be a boost to your after-tax wealth.

I recommend monitoring your IRA investments now and for the rest of the year. Look for a good opportunity to convert traditional IRA and 401(k) assets to Roths at a low tax cost.

Here are some tips for maximizing the benefits of a conversion in 2016.

Convert each investment separately.

Most IRA custodians allow you to convert a specific mutual fund, stock, or other investment without first having to sell it and turn it into cash. In addition, you can put each investment, or similar investments, in a separate Roth IRA. For example, you could put U.S. stocks in one Roth IRA, emerging market stocks in another, and so forth.

This is a good move to make, because the tax law allows you to reverse a conversion any time up to October 15 of the year after the conversion, if you timely file your tax return. In other words, if you convert an IRA in 2016, you have until October 15, 2017, to reverse it (known as a recharacterization).

You’d want to recharacterize a Roth IRA if the investment continued to decline significantly after the conversion. The tax you pay on the conversion is based on the IRA’s value on the date of the conversion. If the value declines, you still pay taxes as of the date of the conversion, so you’re paying taxes on value that no longer exists. You probably don’t want to recharacterize if the decline is fairly small or you expect it to be temporary. Otherwise, it’s a good idea to recharacterize and try to convert at another time.

You have maximum tax efficiency when each type of asset is converted into a separate Roth IRA. If all the assets are converted into one Roth IRA, then you’d want to recharacterize only if the Roth as a whole declined in value. When you have a diversified portfolio, it’s likely some assets will rise and others will decline. It probably won’t make sense to recharacterize even when one or two investments declined.

When each asset is in its own Roth IRA, then you can recharacterize those that continued to lose value but leave those that stabilized or increased in value. You can reconsolidate all the assets into one Roth IRA in the future.

Consider a partial conversion.

An IRA conversion is not an all-or-nothing event. You can convert as much or as little of your traditional IRA as you want (and the custodian will allow). A good strategy is to convert an amount that will keep you from rising into the next highest tax bracket and that won’t trigger the loss of tax breaks for high income taxpayers. You can continue this over several years until you’ve converted all you want, or you can do it only this year to take advantage of the market declines.

We’ve discussed IRA conversions in depth in past visits, and those discussions are in the IRA Watch section of the Archive on the members’ web site.

Here are some key points from those discussions. It is best to pay the taxes on a conversion from other assets instead of taking money out of the IRA. The longer you can let the converted IRA compound before taking distributions, the bigger the pay off from converting. The higher the return you expect after the conversion, the more likely it is the conversion will make sense. If you expect to be in a lower tax bracket when IRA distributions are taken, a conversion might not pay off or will take longer to pay off.