How to Pace Out Roth Conversions

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Feeling patriotic? Show it, then – with a Roth conversion. This year!

On the other hand, relax. You probably won’t hurt yourself too much by waiting another year or two – or even longer. Either way, Uncle Sam will get his money.

An opinion piece in The Wall Street Journal argues that taxes on Roth conversions could reduce next year’s federal budget deficit by anywhere from 15% to 50%. That could really help the country out of a jam.

Two factors could cause a flood of conversions this year. First, wealthier investors with enormous sums in traditional IRAs, 401(k)s and similar plans eligible for conversion will jump at the chance to do it now that they can. Before Jan. 1, conversions were limited to households earning less than $100,000 a year.

Second, anyone who converts in 2010 has the option of dividing the tax bill between 2011 and 2012. In addition to making it easier to come up with the tax money, this could reduce chances the converted sum would kick you into a higher tax bracket when added to your income.

So, the article says, many people will rush to convert this year. Because tax must be paid on most converted sums – everything but nondeductible IRA contributions – that could produce a flood of revenue for the federal government. Hooray!

OK, but what if you just don’t want to do it this year? Conversions may well make sense, as Roth withdrawals are tax-free while money taken from traditional IRAs is taxed. But to make a conversion worthwhile, you must have money lying around to pay the conversion tax. If you pay tax out of sums in the IRA, your new Roth will start out so far behind it may never catch up.

Also, you many not be convinced a conversion makes sense. Conversions are most likely to benefit people who expect to be in higher tax brackets in retirement than they are now, since they can pay at today’s lower rate to avoid a higher rate later. But lots of us figure we’ll have less money in retirement, not more, and no one knows whether tax rates will be higher in the future or not.

So postponing this decision can make a lot of sense.

There’s no ignoring the fact that a delay could cost you money. If you postpone a conversion for two or three years and the stock market soars, your IRAs could be much bigger in the future than they are today. Your conversion tax would therefore be bigger, too.

If that worries you, think about converting in stages, doing just some each year for several years. Start by converting the holdings likely to grow the most over the next few years – probably your stocks and stock funds. Once those holdings are safely tucked into a Roth, all that growth will be tax-free.

Bond funds, money-market funds and other holdings could then be converted later, as you come up with money to pay the taxes. Since they’re not likely to grow as fast as stocks, waiting longer to convert shouldn’t add much to the tax bill.

Remember that in any single year the tax bill on a conversion of a given value will be the same regardless of which holdings you actually move from the IRA to the Roth. To figure the tax, you treat all your IRAs as if they were one and calculate the percentage of the whole that is taxable.

If 80% of the whole is taxable, tax must be paid on 80% of the amount converted. It doesn’t matter whether you convert a stock fund that has tripled in value or a money-market fund that has just held steady.

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