Now that anyone is eligible, you may be tempted to pull the trigger on converting your traditional IRA to a Roth IRA. Qualified distributions from a Roth during retirement are tax free. But you’ll have to pay income tax now on the value of the assets you convert—and if the stock market dips after you’ve made the switch, you could end up being taxed on wealth you no longer have.
However, a Roth IRA conversion doesn’t have to be all or nothing. You can convert some assets in your traditional IRA and maintain the status quo for the rest. Or you could move the entire amount to a Roth in a series of annual steps. This divide-and-conquer strategy may save you thousands of tax dollars.
Prior to 2010, Roth conversions were limited to those with adjusted gross income, or AGI, below $100,000. But now that limit no longer applies, and many people with substantial incomes and assets are considering the pros and cons of a Roth conversion. The biggest con is the tax you’ll owe, which you must pay when you file your return for the tax year of the conversion. Beginning in 2013, the top federal income tax rate is 35%, and you may also owe state tax.
If you have to dip into IRA funds to come up with the cash for the taxes, that will dilute the future benefit of the conversion. As an alternative, you could convert to a Roth gradually, over several years. The smaller amounts each year would be less likely to push you into a higher tax bracket, and it may be easier to come up with the tax money with this pay-as-you-go approach. It could also help smooth out some of the impact of stock market volatility.
Suppose you’re a single filer with $1 million in your traditional IRA and your income normally falls at the low end of the 35% tax bracket. Let’s say you convert the entire $1 million in 2013, with $200,000 taxed at the 35% tax rate and $800,000 taxed at 39.6%. Your total tax would be $386,800 ($70,000 + $316,800). However, if you convert $200,000 of assets each year for five consecutive years, and all of the money is taxed at 35%, you would owe just $350,000 (5 x $70,000)—or $36,800 less.
Of course, this example is hypothetical and numerous other variables, including state income tax, will affect your actual tax liability. Nevertheless, you should benefit if a gradual conversion keeps you out of a higher tax bracket.
One crucial variable is the value of your IRA on the conversion dates. But if the stock market drops and your account loses considerable value, you can generally reverse a conversion if you transfer assets back to the traditional IRA by the due date for your tax return.