Roth Conversion: Do You Have the Headroom?

We’re coming into the time of year when I begin to consider how much of my traditional IRA funds to convert to a Roth IRA. Because there are tax implications one should think Roth conversion through carefully. If you haven’t done this exercise yet this post may help, though there are a lot of other places online to find the same information.

Considering the tax implications of Roth conversion is something more people may be doing in 2010 when the income limits on Roth conversion are eliminated, making Roths available to many who did not previously have access (see the Center on Budget and Policy Priorities report Roth IRA Provision Effectively Eliminates Income Limits on Roth IRAs: Establishes Major New Tax Shelter For High-Income Households).

The first thing to recognize is that every dollar converted to a Roth IRA that has not previously been taxed is taxed upon conversion at your marginal income tax rate. For example, every dollar converted from a tradional (or rollover) IRA is taxed. Earnings converted from a non-deductible IRA are taxed. Assuming you want to pay the lowest possible taxes it is unlikely a good idea to convert your entire traditional, rollover, or non-deductible IRA to a Roth all at once. You’ll probably want to do it gradually, year-by-year. Here’s why:

Every converted dollar that has not been taxed is taxed upon conversion because it increases your taxable income by one dollar. Add enough dollars to your taxable income and you’ll break out of your current marginal tax bracket and into the next one. Suddenly you’re not paying 15% on your converted dollars (if that was your tax bracket) but 25% (the next braket up). Or you’re paying 33% instead of 28%. You don’t have to do that.

You are permitted to convert as much or as little of your IRA funds to a Roth as you like. You can spread it out over as many years as you like. Doing so spreads out the tax payment and gives you an opportunity to match your annual conversion amount to your “tax bracket headroom”: the difference between the top of your marginal tax bracket and your taxable income before conversion.

For example, in 2009 the 15% tax braket for a married couple filing jointly applies to taxable income in the range $16,700 to $67,900. Suppose your taxable income is $50,000 without any conversion funds. You have $17,900 of “headroom” left in the 15% bracket ($67,900 – $50,000). Therefore, you can convert $17,900 of taxable funds to a Roth and only pay 15% tax on those funds.

If you convert more, you’ll pay a higher tax on the additional amount (25% on the next $69,150 of taxable conversion in 2009). But why do that? You can wait until the next tax year to convert additional funds and save on taxes by doing so. This is precisely what I do. Each year, before the end of December, I estimate how much headroom I have in my marginal tax bracket and I convert just enough into my Roth so as not to exceed the top of the bracket. This estimation isn’t precise because I don’t know my taxable income exactly until I do my taxes in March or so, but it is better than guessing and far better than just converting the whole amount.

Caveats and notes: (1) Due to the market downturn, this year it might have been advantageous for me to have converted early in the year an amount beyond the size of my tax bracket headroom. I would have been taxed at a higher rate for some of that conversion but I would have converted at a time when the total was depressed, avoiding taxes in the future when the portfolio recovers. I didn’t do that. I didn’t even try to calculate if it would have been a good idea. (2) In 2010 there is a special option on conversions. You can pay no tax in 2010 and spread the tax due over the two years: 2011 and 2012. For an excellent article on the special 2010 conversion rules see Making a Good Deal for Retirement Even Better (Wall Street Journal). (3) There is also five-year rule that pertains to qualified Roth distributions (of earnings) taken before age 59.5 (an early distribution). The clock on those five years restarts at the time of conversion. If you’re considering taking an early distribution of earnings you should do some more reading about the five year rule. See 5 Year Rule for Roth IRA Qualified Distributions at Good Financial Cents.

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