By now you have likely heard about the opportunity to convert a traditional IRA or 401(k) to a Roth IRA. Most articles on the topic focus on one-time conversions of large lump sums. Less ink is devoted to the idea of smaller annual conversions, which could be very powerful for recently retired Baby Boomers with little earned income.
Converting traditional IRA dollars to a Roth IRA generates taxable income in the year of conversion, a fact that has caused many to shy away. Upon retirement, however, the Baby Boomer has often migrated from a high to a low tax bracket, making such a conversion much cheaper. Someday, they will take distributions from their traditional IRAs that will be taxable at prevailing rates. In the reasonably likely event that their tax rate upon taking these distributions will be equal to or greater than the lowest tax rates available today, they should consider converting traditional IRA dollars to a Roth IRA over time.
At a minimum, convert an amount that will generate enough total income to utilize all deductions and exemptions. That portion of the conversion is tax free. A married couple will claim $19,500 in standard deduction and exemptions (more if they itemize deductions). The strategy will vary by client, but converting enough to reach – but not exceed – the current 10 percent or 15 percent tax bracket may be advantageous (up to $17,400 or $70,700 of taxable income, respectively). This strategy works just as well – if not better – for wealthy individuals, provided taxable income is low.
What does this do?
“Prepays” the tax on traditional IRA dollars at a low current rate.
Reduces the traditional IRA balance, therefore lowering future IRS mandated withdrawals (at potentially higher tax rates).
Lower taxable income from #2 above may reduce taxability of Social Security benefits.
Retains assets in a tax-advantaged account for longer (Roth IRAs do not have mandatory distributions).
Careful planning is required and, since everyone’s tax situation is different, consult your tax advisor to ensure this strategy is appropriate for you.
Michael Rodenbaugh is a senior consultant with Altair Advisers LLC, serving as an independent chief investment officer for wealthy families and entities in the Wisconsin market.