Roth IRAs remain one of the most neglected tax and financial planning opportunities. Even many of those who convert their traditional IRAs to Roths don't take advantage of all the strategies available to maximize tax-free wealth.
It's understandable that people are slow to convert their traditional IRAs to Roths. There are many factors to evaluate to determine whether converting is the right move. I've discussed these factors in past issues of Retirement Watch and in my books, Personal Finance for Seniors for Dummies and The New Rules of Retirement.
Many people don't do the analysis and don't want to pay an advisor to do it. Too many prefer the basic "gut check," rules of thumb, or simple, intuitive analysis, the approach criticized in Daniel Kahneman's book, Thinking Fast, And Slow.
To streamline the analysis, consider using the formula offered by William Baldwin of Forbes. Baldwin says to multiply your portfolio's estimated rate of return by the tax rate on your portfolio and then by the number of years that will pass before you withdraw money from your converted IRA. He calls it RTN. You shouldn't convert if you expect your ordinary income tax rate to decline by more than the result of that formula from working years to retirement. Otherwise, conversion probably is a good idea.
Suppose you expect to earn 6% a year and pay a 20% tax rate for 15 years. Multiplied together, your RTN is about 18%. If you think your ordinary tax rate will decline by more than 18% in retirement from your pre-retirement rate, then you might not want to convert.
Converting to a Roth is almost a no-brainer in at least one situation. When you plan to leave all or most of your traditional IRA to heirs and use it only as emergency cash during your lifetime, conversion is a good idea. Your beneficiary will have a steady stream of lifetime tax-free income. You'll also increase the after-tax value ! of that inheritance by paying the taxes on the conversion. If your heirs inherited a traditional IRA they'd pay ordinary income taxes on all their distributions. By paying the taxes on the conversion you're essentially making a tax-free gift of all the future income taxes they would pay.
Paying taxes earlier instead of later, as required by an IRA conversion, goes against the instincts and learning of most people. But in many cases its pays off.
Once converting to a Roth IRA is deemed to be a good idea, you can make it even better by considering several strategies.
Regularly re-evaluate the decision. Many people who consider IRA conversions undertake the analysis once. After that, if conversion didn't seem a good idea, they don't reconsider.
That's too bad, because things change. Your income might decline. Or you might have a large business loss or other deduction to offset all or part of the converted amount. If a conversion isn't for you, try to figure out why. Then, when there's a specific change in circumstances you'll know if it makes sense to review the decision.
Those who decided to convert also need to review their decision, which we discuss later.
Consider how it affects other taxes. The converted amount is included in your gross income. It will increase your adjusted gross income. That means it could increase taxes on Social Security benefits, increase your Medicare premiums in two years, reduce itemized deductions and personal exemptions, and have other effects. These are likely to be marginal, short-term effects. But you should know about them before the conversion and realize they will be additional costs of the conversion.
Don't forget RMDs. If you're over age 70½ and required to take annual distributions, don't forget to take an RMD from the traditional IRA in the year of the conversion. You are required to take the RMD regardless of when during the year you convert the traditional IRA. Avoid being hit with the penalty and i! nterest b! y taking your RMD before converting the IRA.
Prepay the conversion taxes. You're required to prepay your taxes during the year through withholding and estimated tax payments. If you don't prepay on time, you'll owe a penalty either with your tax return or that the IRS will assess after you file. To ensure you prepay the right amount, check IRS Publication 505 and the instructions to Form 1040-ES.
Combine with charitable strategies. When you're charitably inclined, that inclination could pay for your Roth conversion while generating a stream of income. A large gift to charity or a charitable trust likely will generate a tax deduction to offset the income included from the conversion. It's best to donate appreciated property most of the time, but cash contributions generate benefits, too.
For example, you could create a charitable remainder trust and donate appreciated mutual funds to it. The trust begins paying you an annual income and manages the investments. You receive a charitable contribution deduction for a portion of the donation's value. Perhaps the donation will be enough to make the Roth conversion tax-free. You also could create a charitable lead trust that will pay income to the charity for a period of years and then return the remaining principal to you or your heirs. We don't have space to provide all the details of these strategies here, but discuss them with your estate planner if they seem like good ideas.
Create multiple Roth IRA accounts. You can change your mind about a conversion. Changing back to a traditional IRA is known as a recharacterization. We'll discuss the details shortly, but one reason to recharacterize is that the IRA's value declined after the conversion. The conversion tax is based on the value of the converted amount on the day of the conversion. You still owe the same amount even if the IRA loses value.
It makes sense to set up a separate IRA for each different type of investment that you convert. (You're allowed an u! nlimited ! number of Roth IRA accounts.) When you convert into only one Roth IRA, then you recharacterize only if the entire IRA declines in value. You'll have paid taxes to convert some assets that lost value. But when each asset is converted into a separate Roth IRA, you can recharacterize any that decline and keep those that didn't. You can reconvert the others later.
When you convert into one Roth IRA, you can choose to recharacterize only a portion of it instead of all of it. But you can't recharacterize only the portion that declined in value. Instead, you use a formula from IRS regulations that effectively pro rates gains and losses in the total account between the recharacterization and the Roth IRA. It's more effective to convert initially each type of asset into a separate Roth IRA.
Here's a simple example.
Max Profits has $500,000 of equities and $500,000 of fixed income in his traditional IRA and converts all of it on January 30, 2014. His tax rate is 35%. On April 14, 2015, the stocks in the Roth IRA are valued at $300,000, and the bonds are valued at $600,000. Max wants to recharacterize an amount equal to the $300,000 value of the stocks.
Because Max converted the traditional IRA into one Roth IRA, under the formula in the IRS regulations the partial recharacterization of $300,000 would be treated as though he initially converted $666,666. He would owe a total tax on the conversion after recharacterization of $233,333 (as opposed to $350,000 on the initial conversion.)
But if Max had converted the stocks and bonds into separate Roth IRAs and then chose to recharacterize only the stocks Roth IRA, he would owe only taxes on convert-ing the bonds Roth IRA. The total tax would be $175,000. Then, he soon would be able to reconvert the stocks into another Roth IRA at their lower value.
You might have to first separate your traditional IRA into different IRAs before the conversion in order to convert each asset into a separate Roth IRA.
Have a recharacter! ization s! trategy. The conversion of an IRA is one of the few strategies the tax law lets you change your mind about after the year ends. After a traditional IRA is converted, you can reverse that conversion (recharacterize) any time up until the tax return for the year of the conversion, including extensions, is due. That means for a conversion made in 2014 you have until Oct. 15, 2015, to change your mind.
But it's probably not a good idea to wait until the last minute to recharacterize. You want to keep in mind your option to reconvert the IRA again. I recommend timing your recharacterization so that you are allowed to reconvert a reasonable time afterward. The law allows a reconversion only after the later of 30 days and the next calendar year following the recharacterization.
If you wait until Oct. 15, 2015, to recharacterize, then you can't reconvert until January 1, 2016. But if you recharacterize on Dec. 31 2014, after first converting in 2014, then you can reconvert on January 31, 2015. The rule makes December of the year of the conversion the ideal time to recharacterize.
But you shouldn't ignore recharacterization opportunities before or after that. If a Roth IRA substantially declines in value before the recharacterization deadline, you should consider recharacterizing. Lock in the loss, reduce your tax bill on the conversion, and get set to reconvert in the future.
Once you convert, watch your converted IRAs. You don't want to recharacterize too quickly or after a value decline that is likely to be short-term or is small. But monitor the Roth IRAs' values and the reconversion rules. When an IRA's value is down a meaningful amount, consider recharacterizing. Try to time your recharacterization to maximize your reconversion opportunities. Ideally, events are timed so you can reconvert at the lower value, before the assets recover.
Consolidate converted Roth IRAs after the deadlines. Once the deadlines for recharacterization pass, there's no longer a reason fo! r the Rot! h IRAs to be separate. You should consolidate the Roth IRAs so that management of them will be easier.
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