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Getting timing right on Roth conversions

Getting timing right on Roth conversions
(Dreamstime)

In a recent column, I mentioned the importance of tax planning for your retirement assets. We are living in a time of relatively low historic income tax rates, and as our national debt grows and political considerations change, it's not unlikely that tax rates will rise in the future.

It's always been the conventional wisdom to avoid paying taxes – legally – whenever possible. That's the motivation behind contributions to traditional IRAs and 40l(k) plans. You get an immediate tax deduction for your contributions, and all that money grows tax-deferred – until you withdraw in retirement, paying ordinary income taxes, when you're presumably in a lower tax bracket.

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But now a new question arises: Should you consider converting to a Roth IRA now and paying taxes, instead of waiting for those large required minimum distributions at potentially higher rates?

It certainly makes sense to take advantage of the tax-free growth opportunity for current contributions to a Roth – if you meet the income limitations for modified adjusted gross income of $120,000 for singles and $189,000 filing a joint return. (Above those levels the contribution eligibility quickly phases out.) But what about the money you already have growing in your traditional IRA or IRA rollover account?

Because there is now no income limitation for converting to a Roth, this is where your financial planning gets tricky. When you convert a traditional or rollover IRA to a Roth, you must pay all applicable federal and state income taxes in the year of the conversion.

That means, if you're in the 32 percent marginal tax bracket, and convert a $100,000 traditional IRA to a Roth, you could owe $32,000 in taxes for the year in which you do the conversion.

In fact, adding the converted amount to your current income could push you into a higher bracket. And that might impact what you pay for Medicare Part B or other benefit eligibility.

It's important to consult with your tax adviser before doing the conversion. And you are allowed to do a partial conversion of your IRA, spreading out the tax burden.

There's an even more important consideration. Those taxes should be paid with money held outside your traditional IRA. Otherwise, you'll pay taxes (and a 10 percent early withdrawal penalty if under age 59½), on the extra money you withdraw to pay the conversion tax.

Money in converted Roth accounts must be held for five years and account holders must be at least 59½ before money can be withdrawn tax-free – except in cases of death or becoming disabled. This 5-year period is calculated from the first day of the tax year for which you make your initial contribution to your first Roth account.

That initial contribution can be a regular annual contribution, or it can be a conversion contribution.

Converting a traditional IRA to a Roth is sometimes known as a "backdoor Roth" – an opportunity to make your money grow tax-free from this point on. But just because you now have a Roth IRA does not mean you can make additional future contributions unless you meet the annual income limits.

Roth conversion is now an irrevocable decision. (In the past, you had an opportunity to reconsider and re-characterize the decision to convert.) So the time to do a conversion is when you know you'll be in a lower tax bracket that year and at a point when you think the IRA is near its lowest value.

And there's one more question: Do you believe the government will keep its promise of tax-free withdrawals from Roth IRAs in future years? As the old saying goes, nothing's certain except death and taxes, and especially tax rates and tax promises. And that's The Savage Truth.

Terry Savage is a registered investment adviser and the author of four best-selling books, including "The Savage Truth on Money." She responds to questions on her blog at TerrySavage.com.

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