9 Ways to Nibble Into a Roth Conversion

Everyone would like to own a Roth IRA. Unlike with traditional IRAs, Roth distributions are tax-free, no distributions are required until after the participant's death, and you can withdraw your own contributions first, income tax-free, anytime.

For retirees, the Roth IRA is a source of regular income and/or the occasional needed extra distribution that can be taken without increasing your gross income. Keeping gross income low can help avoid phasing in the bad things (such as the 3.8% tax on net investment income, taxability of Social Security benefits, and/or higher Medicare premiums) and phasing out the good things (such as itemized deductions, personal exemptions, and medical expense deductions).

So what's not to like? The price tag. Because converting a traditional plan or IRA to a Roth IRA is taxed as if the amount were distributed from the traditional plan or IRA, few individuals sign up for huge Roth conversions. Either they can't afford to do it, or they don't want to spend the money even if they could--especially considering that a Roth conversion is not risk-free:

• The government could change the rules to make Roths less favorable (see, for example, President Obama's proposal to require lifetime distributions from Roths).
• Your tax rate could go down instead of up (making a conversion at today's higher rates a bad bargain).
• The Roth's investments could go down in value instead of up (meaning you paid tax on value you didn't get).
• You might someday need the cash that you sent to the IRS to pay for the conversion.

Enter the "nibble." Since few want to swallow the elephant all at once, yet ownership of a Roth IRA is highly desirable, look for ways to take small bites: Do a Roth conversion when you have a chance to do it cheap. Do a small conversion rather than a big one. Pay the price when the cost is affordable.

Here are examples of the types of planning opportunities investors should keep an eye out for:

1. The "backdoor" Roth conversion. An individual under age 70 1/2 who is working and eligible to contribute to a traditional IRA, but whose income is too high to allow direct contributions to a Roth IRA, makes an annual contribution of $5,500 or $6,500 (depending on age) to a traditional IRA. Soon thereafter he or she converts the IRA to a Roth IRA. Assuming the original IRA contribution was nondeductible, and the individual does not own any other IRAs, the conversion will be "tax-free" except to the extent of earnings that have accrued inside the traditional IRA between the date of the contribution and the date of the conversion.

The conversion is not tax-free if the individual owns other IRAs that contain pretax money, as all IRAs are considered one single account for purposes of determining how much of any IRA distribution from any of the accounts is pretax or aftertax money; however, even in that case, this could still be a way to get a limited amount of money into a Roth IRA with a limited cost.

2. Use up temporary losses, deductions, AMT brackets. An individual who has a net operating loss from a business that is greater than the amount of gross income he or she has from other sources, or who has a charitable deduction carryforward, can sop up the business loss or remaining deduction by means of a Roth conversion. The conversion will be "tax-free" to the extent it is offset by the loss or the deduction.

Similarly, an investor who, near the end of the year, discovers he or she will be subject to the alternative minimum tax for the year, may find there is a temporary opportunity to convert some of his or her traditional IRA to a Roth IRA at the AMT tax rate rather than the higher "regular" tax rate that otherwise may normally apply.

And here's a very unusual one to look out for: inheriting a qualified retirement plan from a decedent whose estate is subject to federal estate tax. This person is entitled to an income tax deduction (called the "IRD deduction") that would offset the income from the retirement plan. By directing the plan administrator to transfer the inherited qualified plan to an inherited Roth IRA, the person realizes all the income (but also the deduction, which reduces the tax on that income) in one fell swoop. Unfortunately this does not work for inherited IRAs, which cannot be converted to Roths.

3. Direct aftertax plan distributions to a Roth IRA. This is a new item on the menu, added in 2014. Anyone taking a distribution from a qualified retirement plan or 403(b) plan can use this idea if he or she has aftertax money in the plan: The individual directs the plan administrator to send the aftertax money via direct transfer to a Roth IRA, thus effecting a "tax-free" Roth conversion of the aftertax money. (It's not really tax-free--it's just that the individual has already paid tax on the money, perhaps years ago.)

The individual can direct the plan administrator to send the pretax money from the same plan account (including the earnings on the aftertax money, which are considered pretax money--confusing, isn't it?) via direct transfer to a traditional IRA if he or she wants to continue deferring income tax on those funds. The new ability to do this is causing planners and their clients to figure out whether they can make additional aftertax contributions to their workplace retirement plans, so as to later convert those amounts tax-free to a Roth. Unfortunately this does not work with SEP-IRAs, which are not qualified plans.

4. Contribute to a Roth rather than a deductible traditional IRA. A person who is eligible to contribute directly to a Roth and whose only other alternative is a nondeductible contribution to a traditional IRA will obviously choose the more favorable Roth IRA, since there is no current tax cost to doing so. But even if the person could take a deduction for contributing to a traditional IRA, he or she might choose to forgo the tax deduction and instead contribute to a Roth. Perhaps his or her current income tax bracket is lower than his or her future tax bracket is likely to be. Or perhaps he or she is willing to pay some extra income tax today to get a "little" Roth IRA started, even though a substantial Roth conversion appears too costly.

5. Convert enough to reach, but not exceed, the next income tax bracket. A married-filing-jointly retiree whose taxable income (including required minimum distributions from his or her traditional IRA), before any Roth conversions, comes to about $65,000 is in the 15% marginal income tax bracket. He or she could receive approximately another $9,500 of taxable income without "graduating" to the 25% bracket. This person might convert $9,500 of his or her traditional IRA to a Roth to generate that amount of income, figuring tax at 15% is a bargain, especially if he or she can see ahead that future required minimum distributions will push him or her into a higher bracket in future years. Taking this "nibble" now helps reduce those future RMDs a bit while taking advantage of today's low bracket.

6. Convert to avoid expected future higher tax rates. There is an incentive to convert today if you can look ahead and see that future income tax rates applicable to distributions from the traditional IRA will probably be higher. For example, as Bob Keebler has often pointed out with respect to retired couples, when one of the spouses dies, the survivor often finds him or herself in a much higher "single" income tax bracket even though income hasn't declined accordingly. Married couples should keep an eye on that factor when deciding whether to do some Roth conversions today.

Similarly, a low-bracket retired parent can do piecemeal Roth conversions of a traditional IRA that will otherwise pass upon his or her death to higher-bracket children--or be taxed at high trust rates, if the parent is leaving the IRA to a trust. An unemployed person may take advantage of his or her income "dip" by doing Roth conversions (though unfortunately being unemployed also often means not having the cash to take advantage of such tax opportunities). The classic example is a retired person who is under age 70 1/2, whose income has dropped substantially due to the end of compensation but who has not yet started taking RMDs. There may be low-bracket years in the pre-age-70 1/2 time frame where Roth conversions would not only take advantage of the relatively lower tax rate but also lower the future RMDs by reducing the traditional IRA account balances.

7. A second "buy" decision. Suppose an investor's traditional IRA holds a certain stock that he or she considers undervalued. The stock is now worth $20,000 but the investor strongly expects it to double in the next year or two. One approach to a stock you consider undervalued is to buy some more of it. Here's another idea: Move that stock from the traditional IRA to a Roth IRA, paying income tax today on this "bargain" price. The future expected appreciation will be tax-free in the Roth. (As a reminder, a Roth conversion can be done by moving cash or assets or both from the traditional IRA to the Roth IRA.)

8. Don't forget state taxes! Some investors accumulated money in Keogh plans when Keogh plan contributions were not deductible for state income tax purposes in their state. For example, a self-employed person's retirement plan contributions are not and never have been deductible for purposes of the Massachusetts income tax. The individual may have a substantial state basis in his or her IRA representing these nondeducted contributions to the former Keogh plan. Depending on the applicable state rules for recovery of that basis, the individual may be able to do a substantial Roth conversion without any state income tax.

9. What else are you going to spend the money on? Some people tend to spend any dollars they have in taxable accounts, but draw the line at dipping into retirement funds. Suppose Jane is of that type, and she is getting a $5,000 tax refund that isn't needed immediately for anything in particular. Jane has already made the maximum contributions to her retirement plans for the year. Although she would never dip into her retirement plans, that $5,000 refund is likely to disappear in nonessential spending over the next year. Why not, instead, earmark the tax refund for paying income tax on a $12,500 Roth conversion? This will be a true investment in her future retirement security.

Where to read more: Regarding the rules for Roth IRAs and Roth conversions generally, see Chapter 5 of Natalie Choate's book Life and Death Planning for Retirement Benefits (7th ed. 2011), which may be purchased through Amazon.com or https://www.ataxplan.com/ (print edition; $89.95 plus shipping) or via subscription in an electronic edition at https://www.retirementbenefitsplanning.com/ ($9 per month). For a handy reference source for the current dollar limits on IRA contributions and income limits applicable to Roth contributions, consult Denise Appleby's IRA Quick Reference Guide (http://www.iraeducationcenter.com/; $59.95). Regarding the IRD deduction, see ¶ 4.6.04 of Life and Death Planning for Retirement Benefits, or Natalie Choate's Estate Administrator's Guide to Retirement Benefits (downloadable at www.ataxplan.com). Regarding direct transfers from a qualified plan to a Roth IRA, see IRS Notice 2014-54, 2014-41 IRB (9/18/14).

Natalie Choate will be speaking at a location near you if you live in San Diego (Oct. 24, 2015); Orlando (Jan. 14-15, 2016) or St. Petersburg (Oct. 15, 2015), Fla.; Rosemont, Ill. (Oct. 5, 2015); Philadelphia (July 16, 2015); Knoxville, Tenn. (Sept. 9, 2015); Boston (July 17, 2015 and Nov. 17, 2015); Albany, N.Y. (Oct. 20, 2015); South Bend, Ind. (Sept. 17, 2015); Kiawah Island, S.C. (July 30, 2015); Missoula, Mont. (Oct. 23, 2015); Atlanta (Oct. 22, 2015); Honolulu (Oct. 26, 2015); Dallas (Nov. 5, 2015); Birmingham, Ala. (Nov. 6, 2015); Omaha, Neb. (Dec. 4, 2015); or Minneapolis (Dec. 8, 2015). See all of Natalie's upcoming speaking events.