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How to Maximize the Benefits of a Roth IRA Conversion

Last update on: Oct 17 2017
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Converting a regular IRA to a Roth IRA can be a shrewd financial move. See September’s visit for details. This month we’re going to discuss how to establish a plan that will multiply the benefits of a conversion.

There are two key rules that can be used to develop the most effective Roth conversion plan.

One rule is that an entire IRA does not have to be converted, and all your IRAs do not have to be converted. You can convert an IRA in stages over the years, or convert only a portion of an IRA and no more.

The other key rule for a conversion plan is that a conversion can be reversed. The conversion can be reversed, known as re-characterization, any time before the due date for the tax return for the year of the conversion, including extensions. The extension date can be used even if the taxpayer filed the return by April 15. This means if you converted an IRA in 2005, the re-characterization can occur any time up to Oct. 15, 2006, regardless of when the 2005 return was filed. If the return was filed and taxes on the conversion paid, an amended return can be filed to get a refund of the conversion taxes.

Once re-characterized, the IRA can be left as a traditional IRA, or in the future it again can be converted to a Roth. The second conversion cannot be made in the same year as the original conversion. A second conversion also cannot occur until more than 30 days have passed since the re-characterization.

Remember that when a traditional IRA is converted to a regular IRA, the amount converted is treated as a distribution. It is included in gross income for the year and taxed as ordinary income.

There are a couple of times when a taxpayer might want to reverse a conversion.

One reason to re-characterize is that income for the year (excluding the converted amount) unexpectedly exceeds $100,000. A conversion is not allowed when modified adjusted gross income is more than $100,000. When income exceeds $100,000 a taxpayer who wants the benefits of a Roth IRA has to re-characterize and wait for another year when the $100,000 threshold isn’t breached.

The other reason to re-characterize is that the value of the IRA declined after the conversion. The tax is computed on the value of the converted amount on the date of the conversion. If the value declines after the conversion, taxes still are paid on the previous higher value. To avoid paying taxes on the higher value, the IRA can be re-characterized. The owner can decide to convert again in a new year and after 30 days have passed.

Here is how to apply these basic elements of a wealth maximizing strategy for IRA conversions.

In a year when you are eligible to do a conversion, convert all of your traditional IRAs into Roth IRAs. Make the conversion early in the year. It will be easier for you to monitor things and implement this plan if you first break each IRA into smaller IRAs. Some IRA custodians will allow this, some won’t.

In September or October, review the IRAs. There are two factors to examine.

The first factor is your tax bracket for the year. The converted amount will be added to other income to compute taxes. If you are eligible for a conversion, you probably are in the 25% tax bracket before the conversion.

After your other income for the year can be estimated reliably, determine if the full conversion pushes you above the 25% bracket. You might want to convert only enough to keep you in the 25% bracket, or perhaps the 28% bracket at the most. When full conversion boosts the tax rate, re-characterize the rest of the IRAs. (This is where having multiple IRAs can be convenient.) The rest of the IRAs can be converted again once you are eligible.

Under this process, it could take several years to convert all of your traditional IRAs to Roth IRAs. But it would be done at a lower tax cost, because you would avoid pushing the tax rate on part of the converted amount from 25% to 28% or 35%.

The risk of the multi-year plan is that the IRA might appreciate significantly over the years so that the eventual taxes, even at the 25% rate each year, are greater than taking the full hit in the first year at 28%.

Likewise, you probably do not want to re-characterize an IRA that has appreciated significantly during the year, even if the conversion pushes you into a higher bracket.

Here is how to analyze the trade-off between a higher tax rate today and a higher IRA value in the future to determine the best time to convert.

Suppose you convert a $50,000 IRA, and that pushes you into the 28% bracket. Paying the higher tax rate on that IRA would cost $1,500 in additional taxes. Suppose that IRA is re-characterized, then re-converted the next year at the 25% rate. If the IRA appreciates $6,000, the total tax at 25% next year is the same as 28% this year. You should keep the conversion and pay taxes this year if there is good reason to think that the appreciation will exceed $6,000 by next year. The formula to find the tipping point is to divide the additional tax this year by .25.

You can minimize the danger of higher taxes from appreciation by reconverting as soon as eligible after a re-characterization.

The second factor to monitor is the value of the IRA. An IRA that has declined in value should be re-characterized, with another conversion considered when eligible.

If all of the converted IRAs declined in value, re-characterize all of them and convert again in the future.

The values should be monitored right up to the deadline for the re-characterization. You might have converted an IRA in January 2005. The investments in the IRA might be subject to a bear market in mid-2006. You can do the re characterization any time up to Oct. 15, 2006. So, keep monitoring the value until the final deadline for re-characterization has passed.

Before beginning a conversion plan, check the fees charged by your IRA custodian. Some will charge for each conversion and re-characterization. Also, be sure the custodian does not impose restrictions in addition to those of the IRS. If your custodian could impede your plan, switch custodians.

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