Roth IRA conversion

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Roth IRA conversions are permitted by US tax regulations. If you have a Traditional IRA, you can convert part or all of the account to a Roth IRA. You pay taxes as if you withdrew the entire amount converted, but without any penalty for early withdrawal; in return, the money will grow tax-free in the Roth IRA, and you will not pay any tax on that withdrawal if you meet the Roth IRA distribution rules. The gain or benefit depends on your current marginal tax rate, your expected marginal tax rate in retirement, and how you would otherwise invest the funds that you use to pay the taxes.

How to convert

With Vanguard, to convert, you buy shares (or open a new account) in your Roth IRA, and fund it by "selling" shares in your Traditional IRA. If you convert shares in the same fund, you have not actually sold anything, so Vanguard will not charge a purchase fee or redemption fee on the conversion. Likewise, with other providers, notify the provider of which amount you want to convert.

You can undo a conversion by recharacterizing your conversion through October 15 of the year after you made the conversion. This treats the conversion as if it never happened, giving you a refund of the taxes if you have already paid them, and you can re-convert again later, so you may want to consider recharacterization if you converted and the value of your IRA declined substantially.

All Roth IRA conversions are reported in Part II of IRS Form 8606. [1]

Whether to convert

Rules of thumb

If you expect to be in a lower tax bracket in a future year, wait until that year to convert. Likewise, if converting the whole IRA would push you into a higher tax bracket, convert only as much as will keep you in the current bracket, and convert the remainder in future years.

If your IRA contains substantial non-deductible contributions, convert as soon as possible.

Otherwise, compare your current marginal tax rate and your expected marginal tax rate in retirement, and consider where you would invest the money for the tax payment if you choose not to convert. Conversion is less attractive if your retirement marginal tax rate is lower than your current marginal tax rate, and more attractive if the tax payment would have to be invested in an inferior investment.

If your current marginal rate is lower than your expected retirement tax rate, you should convert in preference to any investment except a matched contribution to a retirement plan. If the rates are equal, max out your Roth contribution in preference to converting, but convert in preference to maxing out your 401(k). If your current rate is slightly higher, max out a decent 401(k) or Roth in preference to converting, but convert in preference to investing in a taxable account. If your current rate is much higher, do not convert.

For calculations which illustrate these principles, see Traditional versus Roth.

Other considerations

A good time to do Roth conversions would be in years when your income is lower:

  1. when unemployed or working fewer hours
  2. when going back to school full-time instead of working
  3. when taking time off to care for a family member
  4. in early retirement before Social Security is collected

If you might retire before taking Social Security, you are likely to be in a very low tax bracket before Social Security starts. To see if Roth conversions would benefit you during this time, estimate your taxes and marginal tax bracket during the early retirement period as well as for the years you are over age 70 and taking Social Security (if eligible) and Required Minimum Distributions (RMDs) from tax-deferred accounts. If your post-age-70 tax bracket is higher, it may be advantageous to you to convert during the early retirement period, while delaying Social Security. It can an advantage for converting to a Roth early, as IRA withdrawals are counted as income for determining how much Social Security is taxable, while Roth withdrawals, which are based on already-taxed money, are not taxed again (assuming the withdrawals occur when you are over age 59.5 and the Roth has been open 5 years).

Recognize three cautions regarding taking conversions during retirement:

  1. If you are drawing Social Security, a Roth IRA conversion could result in a one-year increase in the taxable portion of your Social Security benefits. Total income for Social Security purposes is defined as half of your benefits plus any other income, including tax-exempt income. This income level determines the taxable percentage of your benefits (0%, 50%, or 85%). Keep in mind that future distributions from a Roth won't affect the taxation of your Social Security benefits, which may help you in the long run.
  2. Medicare premiums depend on your modified adjusted gross income (MAGI) from the previous two years (for example your 2009 MAGI determines your 2011 premiums). A Roth conversion reported in a given year will increase your MAGI for that year and therefore may increase your Medicare premiums two years hence. Most retirees pay the standard Medicare Part B premium—about 25% of the total cost—with the U.S. government paying the rest. For affluent individuals, if your MAGI exceeds certain levels (for 2016, $85,000 MAGI single; $170,000 joint)[2] your premium will likely be higher. [3]
  3. After you reach the calendar year you attain age 70 1/2 and must start Required Minimum Distributions (RMDs) from traditional IRAs, the full RMD must be completed before you make any Roth conversions. So for example if you perform a Roth conversion in the 4th day of the new year and take the RMD on the 5th day or later, the IRS will consider the Roth conversion funds to have actually been RMD funds that have been improperly moved into the Roth account.

If you are eligible for tax credits now, find your true marginal tax rate, not your tax bracket, and use that in the decision whether to convert. If you are in the 25% tax bracket but increasing your income by $1000 causes a tax credit to phase out and costs you $50 in credits, your actual marginal tax rate is 30%.

A Roth IRA is exempt from required minimum distributions while you are alive. Therefore, if the Roth conversion is close to break-even but you might be forced to take distributions from your Traditional IRA which are more than you need to live on, there is an advantage to conversion; you will keep more money growing tax-deferred for longer.

Using a spreadsheet

Forum member BigFoot48 has created a spreadsheet for use by retirees, or those nearing retirement, which will estimate the financial impact on your portfolio, including income taxes and RMDs, from doing Roth conversions. Use this spreadsheet to determine if Roth IRA conversions may be worthwhile for your personal situation.

Yearly results are calculated and provided (such as income, expenses, taxes, inheritances, and asset sales over a selectable 1 to 40 year period) for both doing conversions, and not doing conversions, so an easy comparison can be made.

Warning for future recharacterizations

A recharacterization of a Roth conversion is an "un-do" of the Roth conversion or part of one. You will likely want to do one if:

  1. the value of the converted amount has dropped substantially, as when the stock markets drop
  2. you find that you can't afford to pay the increased taxes due to the conversion
  3. part of the conversion pushes you into a higher tax bracket
  4. you end up having higher income later in the year that you weren't expecting

Although the complete details of the recharacterization are discussed in IRA recharacterization, the only choice you will have at recharacterization time is how much of the original conversion you want to un-do and the fund(s) from which you want the money withdrawn.

More importantly, in many respects, are the choices you make when you convert. You can chose which fund(s) to convert, which Roth to convert into, which fund(s) in the new Roth to use, and the amount to convert. Since the choices you make at conversion time will determine what happens at recharacterization time. you should understand recharacterizations before converting, so you aren't surprised at what happens or at the tax implications at that time.

The primary recommendation when you convert is to always convert into a new (empty) Roth. If you are converting multiple holdings (funds, stocks, bonds), put each one into a new, separate, empty Roth. This will allow you to specify what you want returned to the traditional IRA, should a recharacterization be needed.

To understand recharacterizations, look at the affected Roth on the day you convert. Calculate the percentage the converted amount is, compared to the whole account. When you recharacterize that conversion, the custodian has to remove the same percentage of the account value on the day of recharacterization (assuming no other additions or withdrawals were done). The custodian is responsible for calculating the exact dollar amount that needs to be removed, based on the percentage or dollar value of the original conversion you ask to be recharacterized.

Sounds simple. So let's look at some examples.[4]

Example 1. On the day you convert, your Roth contains $100K of fund A and $100K of fund B and you convert $100K of fund X into the same account. The conversion is 33.33% of the account's value on the day of conversion. When you find out that the taxes on the conversion are more than you expected, you decide to recharacterize, but fund A has grown to $120K, fund B has grown to $110K, and fund X is still worth $100K making an account value of $330K and you have to remove 33.33% of it or $110K. Which fund(s) would you decide to recharacterize? (By the way, you don't have to recharacterize from the same fund you added to during the conversion.) The "extra" $10K you have to recharacterize is NOT from a contribution. It is 33.33% of the $30K that the account grew.

Example 2. On the day you convert, your Roth contains $100K of fund A and $100K of fund B and you convert $100K of fund X into the same account. The conversion is 33.33% of the account's value on the day of conversion. When you find out that the taxes on the conversion are more than you expected, you decide to recharacterize, but fund A has decreased to $80K, fund B has decreased to $90K, and fund X is still worth $100K making an account value of $270K and you have to remove 33.33% of it or $90K. Which fund(s) would you decide to recharacterize? The "lost" $10K you don't have to recharacterize is NOT from a contribution. It is 33.33% of the $30K that the account lost.

Example 3. On the day you convert, your Roth contains $100K of fund A and $100K of fund B and you convert $100K of fund X into the same account. The conversion is 33.33% of the account's value on the day of conversion. When you find out that the taxes on the conversion are more than you expected, you decide to recharacterize, but fund A has grown to $115K, fund B has decreased to $85K, and fund X is still worth $100K making an account value of $300K and you have to remove 33.33% of it or $100K. Which fund(s) would you decide to recharacterize?

Example 4. On the day you convert, you open a new (empty) Roth and you convert $100K of fund X into it. The conversion is 100% of the account's value. When you find out that the taxes on the conversion are more than you expected, you decide to recharacterize. Regardless if the account value has changed or not, if you recharacterize the whole conversion, 100% of the account value will be removed.

Example 5. Same as example 4, but you can afford the taxes. However, the money was invested in a stock fund which lost half of its value. Do you still want to pay taxes on a $100K conversion that is now only worth $50K?

After doing a Roth conversion and there is still a chance of recharacterizing it, you should not move the Roth account to a new custodian or another Roth, since it may not be possible to obtain the custodian's records for the original conversion.

If you did the Roth conversion on Vanguard's "old" platform (where mutual funds were/are held in 11-digit account numbers and brokerage accounts were/are in 8-digit account numbers) and there is still a chance of recharacterizing, DO NOT upgrade during that time to the "new" platform where mutual funds may be merged into the 8-digit brokerage account. This is because the Vanguard "upgrade" process may "simplify" your accounts by merging your Roth accounts together and thus void the whole point of keeping the converted amount in a separate account.[5]

Converting with non-deductible contributions

If you have non-deductible contributions in your IRA, you do not pay tax on the amount of non-deductible contributions. If you make a partial conversion, you must prorate your deductible and non-deductible contributions across all IRAs (including SEP and SIMPLE IRAs) as of December 31 of the year you convert. For example, if you had a traditional IRA worth $10,000 that contained $5000 in non-deductible contributions and you converted (or withdrew) $3000 leaving $7000 in your IRA at the end of the year, then half of the $3000 is taxable. To compute the taxable amount of your conversion, use IRS Form 8606.

Since the amount of non-deductible contributions does not increase as the IRA grows, there is a tax advantage to converting quickly. If you wait for your $10,000 IRA with $5000 in non-deductible contributions to grow to $20,000 before converting, you pay tax on $15,000 rather than $5000, tripling the tax but only doubling the amount converted.

In particular, if you have no Traditional IRA now, and are eligible to convert a Traditional IRA to a Roth but not eligible to contribute directly to a Roth, you can make a backdoor Roth IRA contribution. You can contribute to a non-deductible Traditional IRA and then convert immediately; you will pay no tax on the conversion (except for market fluctuations in the few days between contributon and conversion), and thus you have effectively contributed to a Roth. (If you already have a Traditional IRA which you do not want to convert, then you cannot use this technique to make a tax-free contribution to a Roth, as any partial conversion will be partly taxed.)

See also

References

External links