Being wealthy doesn't mean having all the money in the world, just not having to worry about it.

Converting a Traditional IRA to a Roth IRA

Question: I am 68, average health, with a 63-year-old wife, healthy. Is there any wisdom to converting a current IRA to Roth?

Answer: Traditional IRAs give a tax deduction up front, but distributions are fully taxable. Roth IRAs provide no tax benefit up front, but distributions are tax-free (so long as they aren’t premature).

In theory you should prefer the traditional IRA when you are in a high tax bracket and a Roth IRA when you are in a low one. The same, in principle, applies to conversions: you should convert assets from a traditional IRA to a Roth IRA to the extent you can do so in a lower tax bracket than the one you’ll face when you would otherwise be distributing the money. You’ll pay taxes in the year of conversion to the Roth rather than the normal distribution year for the traditional IRA assets.

Now, there are complications caused by:

  1. Social Security benefits — Roth distributions, being tax-free, don’t increase the amount of Social Security benefits subject to taxation if you are in the zone where this tax phases in. So I would tend to favor conversion if you are not yet collecting SS benefits — but make sure to account for the increased taxation before converting in the same year as the benefits are being received. (For every dollar of income in the phase-in zone, an additional 50 cents of SS is taxable.)
  2. A preference to bequeath rather than spend your money — Distributions must start after you turn 70 1/2 for traditional IRAs but can be postponed until death for Roths. So I would tend to favor conversion if your goal is to pass money on to your heirs.
  3. Estate taxes — The taxes resulting from conversion reduce the estate and thus the estate tax for those wealthy enough to have it apply. So I would tend to favor conversion if the estate is going to be subject to federal estate taxation at the extremely high rates that currently apply.
  4. Available taxable assets — Since conversion results in current taxation, there have to be available funds in taxable accounts to pay the tax bill.

The decision is complicated enough to be made with the advice of a professional. For the do-it-yourselfer, my suggestion is to convert enough to end up with taxable income at the top of the current 15% tax bracket. (If a few dollars go into the next, 25%, bracket, it only applies to those few dollars, so don’t be too worried about perfection.) In 2016 the 15% tax bracket extends to $37,650 for a single individual and $75,300 for a married couple filing a joint return. Of course, gross income could be much higher, since taxable income is the income after claiming deductions and exemptions. A single individual is, at a minimum, entitled to a $4,050 personal exemption and $6,300 standard deduction, which would allow at least $48,000 gross income, and a married couple would, at a minimum, get two personal exemptions of $4,050 each and a $12,600 standard deduction, allowing at least $96,000 gross income in the 15% bracket.

A couple 68 and 63, using the standard deduction, could bring income to $97,250 (because of a $1,250 increase in the standard deduction allowed for age) and stay in the 15% bracket, ignoring Social Security complications. (It could be as high as 22.5% with Social Security considered, but that is still lower than the next bracket of 25%.) Above that, I’d hesitate to convert.

Now, the best time to convert is early January (hence the timing of this answer). For one thing, all of the year’s earnings will end up occurring in the tax-free Roth IRA. For another, you’re allowed to change your mind, in whole or in part, up to the due date, extensions included, of the tax return for that year. So if you convert on January 4, 2016, you have until October 15, 2017, as long as you file an extension of your return, more than 21 months later, to reverse the conversion. (Reversal is called “recharacterization.”) You might do that if the investments decline in value after conversion or if your income ended up higher than expected and will be taxed at a higher rate than expected (or simply result in more taxes than the cash on hand to pay it).

But here is why an adviser may be needed: the recharacterization must include the pro rata gain or loss from the conversion date, and if you convert to different Roths the measurement of gain and loss is done separately for the different accounts under current law (and laws keep changing, which is another reason to consult with an adviser).

This is why I suggest that DIY investors keep it simple: convert based on your best guess of the amount that will take you to the top of the 15% bracket this year, and then spend your time enjoying retirement rather than obsessing over every dollar of taxation.