In 2010, Roth IRA conversions became available to everyone because limits based on income and filing status were lifted. A conversion is typically a shift of pre-tax IRA money to a Roth IRA. The main benefit of a Roth conversion is that the money grows tax-free once inside the Roth IRA. The price of the conversion is that the amount moved is taxed in the current year as income. It takes time to recover from the initial tax bill, but the savings over time can be substantial.
For example, let’s say you retire at 59 and your new taxable income is $33,800 from pensions, investment earnings, and/or part-time work. You could convert $40,000 from a traditional IRA to a Roth IRA and stay within the 15% tax bracket (up to $73,800 of taxable income in 2014 for Married Filing Jointly). If you take advantage of this over the next 3 years, you can convert a total of $120,000 ($40,000x 3 years) into a Roth IRA. You do, of course, have to pay taxes on the conversions, but remember, you would eventually pay tax on this money at RMD (Required Minimum Distribution) age AND anything it earns if left in your traditional IRA.
Here’s the savings: The $120,000 now in the Roth IRA would earn about $340,000 over 20 years, if invested at 7%. Not having to pay taxes on the $340,000 of growth at 15% tax saves you $51,000! This would be even more savings if your tax rate is higher in the future.
Why did we stop after 3 years? If you plan to draw Social Security at 62, the additional income from the Roth IRA conversion may cause your Social Security benefits to become taxable, thus reducing the savings of conversion.
No one pays federal income tax on more than 85% of his or her Social Security benefits. For example, if you file a joint return and your combined income is between $32,000 and $44,000, you may have to pay income tax on up to 50% of your benefits. If more than $44,000, up to 85% of your benefits may be taxable.
Once again, you may be able to move a substantial portion of your IRA to a Roth IRA. As a great side benefit, lowering your IRA balance could lower your future RMDs. This could mean less tax on Social Security income later, and less total taxes paid. As you can see, in order to take full advantage, it is important to be aware of this window of opportunity and all the specifics.