The idea of converting a traditional IRA to a Roth (atax-free IRA) is to gain two advantages:
- Allow the IRA funds to continue to grow tax free.
- Pay the income tax due now on the current balance, rather than pay tax on your hopefully bigger balance in the future.
This conversion is only beneficial if you can pay the tax with non-IRA funds. If you must use IRA funds to pay the tax, there is no benefit to the conversion.
The other potential benefits of conversion I explain below:
- Because there are no mandatory distributions from a Roth IRA, for people over 70 ½, owning a Roth vs. traditional IRA results in lower taxable income:
- The lower taxable income could possibly mean lower tax or no tax on social security income (since the taxation of social security income is based on the amount of adjusted gross income).
- In the case of a couple, when one spouse dies, and if the household income remains unchanged, the survivor’s income taxes may rise (because single individuals pay more than married individuals for the same amount of income). By having a Roth IRA which does not require minimum distributions, the impact of the potentially higher tax bracket for the survivor is reduced.
- Because the IRA account is not eroded by mandatory distributions, a larger, tax-sheltered account can be passed on to heirs. However, this can be bad from the standpoint of estate taxes, as the hopefully growing account increases the size of the estate.
- Because the Roth conversion tax must be paid at the time of conversion, the estate is immediately reduced by the amount of the income tax. This is favorable for a taxpayer with a taxable estate.
- You can continue to make contributions to a Roth IRA past age 70½ so long as you have earned income (not so with a traditional IRA).
But even you want those advantages and are now running down to your IRA custodian convinced that you want to do a conversion, wait. You may not qualify.
For a single or married person filing jointly, if your adjusted gross income exceeds $100,000, you cannot convert. I know this may not be logical—why can a single man earning $99,000 convert, but if he marries a woman earning $2,000, and their adjusted gross income is now $101,000, neither of them can convert? No one said that tax laws were logical, but I suggest you obey them. If you are contemplating marriage and a Roth conversion, just have that difficult conversation with your fiancée, “I’m sorry dear, we must put off the wedding date until I complete my Roth conversion.”
Note that the required mandatory distribution from your traditional IRA is not counted in that $100,000. So if you have $99,000 income from investments and $20,000 income from the mandatory distribution from your IRA (because you are past age 70 ½), only the $99,000 is counted for the conversion test. Additionally, you may be able to engineer your income below $100,000 for one year in order to convert by:
- Deferring income.
- Moving investments to non-taxable accounts.
- Contributing to a 401(k), 403(b), Keogh, or SEP if eligible.
- Selling capital assets with unrealized losses (stocks, real estate).
- Any other action that will reduce your adjusted gross income.
For purposes of the $100,000 test, the amount that you convert, although it is taxable income, is not counted.
You don’t need to convert your traditional IRA all at once. To spread out your tax bill, you can do partial conversions each year.
If you’re not sleeping by now, you may be asking yourself this clever question, “When I convert my IRA, I need to do it during the calendar year before I know what my adjusted gross income will be for the year. What if I convert and it exceeds $100,000?”
Not a problem. You have until the filing date of your return plus extensions (as late as October 15), to reattribute the Roth and reverse the transaction (the official tax term for this is “recharacterization”) like it never happened. You file an amended return if you have already filed before you do the re-characterization and all is right with the world.