With 2010 fast upon us, the option of converting a traditional IRA into a Roth IRA opens up for millions of investors no longer barred by the $100,000 income limit. Now begins the tricky process of choosing which investments to convert, and when.
That’s no problem for anyone who has decided to convert all traditional IRAs into Roths at once. But many investors will shy away from this because the tax bill would be too high, or because the conversion would lift them to a higher tax bracket.
Others may want to hedge their bets. Conversions make the most sense for people who expect to be in higher tax brackets when they withdraw IRA funds in retirement. Investors who think this could be the case, but aren’t sure, can better control future tax bills by keeping both types of IRAs. That way they will be able to take tax-free money from their Roths in high tax years, and from their traditional, taxable IRAs in years when taxes are low.
Anyone doing a partial conversion must decide which traditional IRA accounts, or which assets in those accounts, should be moved into a Roth. Should it be the big winners or the big losers, for instance?First, let’s talk about what you cannot do: cherry pick candidates to minimize or eliminate the conversion tax. That would be possible if each converted asset were taxed individually. You could then convert a holding that had lost money, like the United States Natural Gas ETF (Stock Quote: UNG), down about 55% this year, so there would be no tax.
But the rules don’t allow that. Instead, all traditional IRAs are lumped together to determine what percentage is taxable. That is the portion attributed to deductible contributions and investment gains. Non-deductible contributions are not taxed upon conversion. If 80% of all your IRA holdings are taxable, 80% of your converted amount is taxed, even if the conversion is from a single, relatively new IRA composed entirely of non-deductible contributions.
So choosing a conversion candidate has no effect on the immediate tax bill. It could, however, have a big effect on future taxes if you intend to keep some of your holdings in a traditional IRA, as withdrawals from that account will be taxed.