Converting a traditional IRA to a Roth IRA can be expensive in tax consequences, especially if the transaction kicks you into a higher tax bracket. Brokerage firm Merrill Edge suggests that one way to control your tax bite is by converting only a part of your IRA assets. With a long-enough time window, you can eventually convert your entire IRA through a year-by-year series of partial conversions. However, you'll need to consider the pros and cons of doing so so that you make a decision that fits your tax situation.
Time Frame for a Roth IRA Conversion
Any IRA-to-Roth conversion will be charged against your taxes in the year you make the conversion. Although you have until the tax-filing deadline of April 15 (or the extended deadline such as in 2020 and 2021) of the following year to make IRA contributions, any conversion must be completed by December 31.
It is often advised to make Roth conversions later in the year when you have a better idea of what your total annual income will be. The other benefit to a late-year conversion is that the date of the account will be recorded as January 1 of the year of conversion for purposes of the five-year rule.
For example, if you elect to make a Roth conversion in November of 2021, the date of record for the account will be January 1, 2021. This means that no time is lost for waiting until later in the year to make the Roth conversion and you can begin taking penalty-free withdrawals after January 1, 2026.
Limits on Roth IRA Conversions
You are allowed any number of conversion transactions during the year. The taxable amount for each conversion will be the value of the assets on the date of transfer. The year 2020 was considered a great year for Roth conversions because of market declines early in the year due to COVID-19. Partial conversions are a common choice for Roth IRA conversions that are made earlier in the year.
Not only does the partial conversion help to reduce taxable income it can also guard against exceeding annual contribution limits. There are no limits on conversions, so a taxpayer can always make more conversions later in the same year.
Can You Recharacterize a Roth IRA Conversion?
Recharacterization is the ability to reclassify an IRA contribution or reverse an IRA conversion. For example, if you contribute to a traditional IRA expecting a higher income, but later realize your income level will be within the threshold to allow for a Roth contribution, it can be recharacterized from the traditional IRA to a Roth IRA contribution. Recharacterizations can not exceed the annual contribution limits outlined by the IRS.
The Tax Cuts and Jobs Act of 2017 changed the rules regarding Roth recharacterization by eliminating the option to recharacterize a Roth conversion after December 31, 2017. Therefore, a Roth conversion will generate taxable income in the year of the transaction according to CPA Journal. Only contributions to Roth IRAs that have never been converted can be recharacterized.
Since recharacterization is no longer an option for converted Roth IRAs, many investors choose to make partial Roth IRA conversions in order to minimize the tax liability that will be imposed on the conversion.
What Should You Consider?
Roth IRA conversions cannot be recharacterized, which means that the decision to reconvert the account into a traditional IRA is no longer available. This makes being certain about annual income quite important.
Tax rates and market conditions are major considerations when deciding to make a Roth conversion. Low tax rates and market declines can provide attractive conditions for a Roth conversion, especially if you believe that your tax bracket will be high after retirement.
The entire Roth conversion will be taxable in the year it occurs, which can make partial conversions taken over multiple years a desirable option. Bear in mind that if the taxes owed on a Roth IRA conversion come from a retirement account, that amount will be considered a distribution and can be subject to the 10 percent penalty for early withdrawal.
Dale Bye has spent more than 40 years in journalism, including 25 supervising reporters and editors at metropolitan newspapers and eight years as senior managing editor at a national sports magazine. He directed five newspaper-sponsored personal finance fairs. His fields of expertise include business and personal finance, sports, fitness and theater. Bye holds a Bachelor of Journalism from the University of Missouri.