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 Converting assets from a traditional IRA to a Roth is worth
considering in any year as a way to diversify retirement holdings
for tax purposes. But the case for conversion - also known as a
backdoor Roth - is more compelling than usual this year for
investors holding IRA investments that have declined in value. Any
amounts you convert are taxed as ordinary income, and a diminished
asset generates less tax liability - or allows you to convert larger
sums.
Roth IRAs accept only post-tax dollars, and generally, distributions
are tax-free on accounts open at least five years, assuming the
distribution is made after age 59-1/2. Contributions can be
withdrawn at any time (earnings and assets converted from
traditional IRAs are subject to the usual IRA penalty rules).
Contributing directly to a Roth is almost a no-brainer for young
retirement savers, who tend to be in lower tax brackets and will
benefit most from years of tax-free investing.
However, contributions are subject to the same annual limits as
traditional IRAs ($5,500 in 2015 and 2016, or $6,500 for savers age
50 or older). Direct Roth contribution are also phased out for
higher-income workers.
Conversions, on the other hand, spark a pay-now or pay-later
question. They make the most sense for older retirement investors
who tend to be in higher tax brackets. “A market decline alone
doesn’t mean you should do a conversion,” cautions Tim Steffen,
director of financial planning at Robert W. Baird & Co. “But in the
right situation, it does make conversion less expensive.”
As retirement approaches, a strong case can be made for diversifying
your holdings between tax-deferred and post-tax accounts. Most
people assume they will be in a lower tax bracket after 70. But
leaving everything in a tax-deferred IRA or 401(k) actually can push
you into a higher tax bracket in retirement because of required
minimum distributions (RMDs), which begin at age 70-1/2. RMDs are
not required with a Roth.
At the same time, reducing the value of your tax-deferred holdings
will reduce your required RMDs from those accounts.
“Diversifying your holdings really gives you a lot of flexibility to
be as tax-efficient as possible in retirement,” said Maria Bruno,
senior investment analyst with Vanguard Investment Strategy Group.
DO IT RIGHT
A particular sweet spot for conversions are people who may no longer
be working, but have not yet filed for Social Security, and
therefore may be in lower tax brackets, Bruno said.
If squeezing in a 2015 Roth conversion before the Dec. 31 deadline
appeals to you, here are some tips for doing it right:
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* Do not convert unless you can fund the tax liability with assets
outside your IRA.
Using IRA assets to pay taxes and fees makes it difficult to come
out ahead in the long run, research from Robert W. Baird & Co.
shows.
“You need to get as much inside the Roth as possible to let it grow
tax free,” Steffen said.
Also remember that if you are younger than age 59-1/2, you will pay
an additional 10 percent penalty on top of the tax.
* Consider a partial conversion that “fills up” your current tax
bracket.
Going just up to the limit of your current bracket will help to
minimize your tax liability.
* Keep in mind you always have the option of a “do-over” in 2016 if
the conversion decision looks less attractive later.
If you convert $50,000 in mutual fund assets to a Roth before the
end of 2015, but by March 2016 the fund’s value falls to $40,000 -
you might want a “recharacterization.”
The recharacterization period begins on the day of conversion and is
open through the due date of your tax return for that year. But you
can use extensions to push it to October 15th of the year following
the year of conversion. (The rules on recharacterization are
somewhat complex, so consult with your tax adviser.)
(The writer is a Reuters columnist. The opinions expressed are his
own.)
(Editing by Beth Pinsker and Dan Grebler)
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