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Ideal Roth Conversion Candidate – Low or No Tax

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One of the planning options that most all folks have available to them is the Roth IRA Conversion.  For the uninitiated, a Roth IRA Conversion is a transaction where you move money from a Traditional IRA or a Qualified Retirement Plan (QRP) such as a 401(k) into a Roth IRA.  With this transaction, if any of the funds in the original account was pre-tax, that amount would be included in income as potentially taxable in the year of the Conversion.

As you might expect, making a decision like this can result in a considerable tax impact, depending on the individual circumstances.  A Roth IRA Conversion may make a great deal of sense for one individual, while another may decide that the Conversion cost is too great for the result.  Detailed below is one specific circumstance that indicates a Roth IRA Conversion is a good move – although each individual needs to consider his or her situation carefully, because every situation is unique.

Low (or Zero) Tax Rate

If an individual is in a situation with a very low tax rate, a Roth Conversion could be a good idea – especially if the situation with the low tax rate is due to change in the future.

An example would be if Joe, a 30-year-old, finds himself taking a year off to go to school and pick up the last few hours of his Master’s degree.  Joe has had a good career in sales for the past several years, and he put $100,000 into his former employer’s 401(k) plan.  The account grew to $150,000 by this year, when Joe has started going to school, intending for his Master’s degree to allow him to advance further in his career.  Joe also has a fairly significant taxable investment account, some of which he plans to use for living expenses, but he also has some extra money in the account which could be used to pay taxes on a Roth Conversion.

Since Joe supports himself and he is a single filer, he should consider converting a portion of his 401(k) account (all pre-tax money) to a Roth IRA.  This is because, having no other income for the tax year, the first $9,750 of income that he claims on his tax return will have zero tax (for 2012) because of the standard deduction and personal exemption.  After that, his next $8,700 of income claimed is taxed at 10%, for a tax cost of $870 for a total conversion of $18,450 – an effective rate of 4.7%.

He could further convert up to an additional $26,650 at the 15% rate, for a total converted amount of $45,100.  The total tax cost of his conversion would be $4,868, for an effective tax rate of only 10.8%.  Taking this a step further, the 25% tax rate would be used for up to $50,300 more of conversion.  This would result in a total of $95,400 being converted, and a total tax of $17,443 – for an effective tax rate of only 18.3%.

Since Joe expects that his income in the future will be much higher – into the six-figures category, it probably makes sense for him to convert as much as possible in these lower tax brackets while his income is actually zero for the year.  Even though it will cost him $17,443 from his taxable account to pay the tax, this is a far lower rate than he could expect to pay on withdrawals from this account in the future.

It should be noted that one of the very important factors in this scenario is that Joe has other funds from which to pay the tax.  If he didn’t have this money available from a source other than his IRA, a portion of the IRA would have to be used to pay the tax.  This would result in imposition of the 10% early withdrawal penalty in addition to the tax on the distribution.  The additional cost of this distribution would weaken the position and increase the overall cost of the conversion.

Conclusion

There are many other situations when a Roth Conversion makes a lot of sense, the above is one example of a very good scenario for the conversion.  As I mentioned previously, each individual’s situation will be different and may or may not result in the same decision to convert or not.  Watch for more examples in future posts!

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4 Comments

  1. […] This is the second in a series of posts about Ideal Roth Conversion Candidates.  See the first post, Low or Zero Tax, at this link. […]

  2. JohnNo Gravatar says:

    Jim,
    I will certainly keep my eye out for that article on Friday. I have thought about the impact of the amount of Roth Conversion before taxation on SS starts. I don’t have to worry about that for a few years but when I turn 66, my wife will be drawing on her SS and I will be doing a Spousal Benefit, deferring my SS until 70. To avoid taxing of SS I may have to cut back on the amount I convert, but maybe I will learn something in your Friday article that will help.
    John

  3. JohnNo Gravatar says:

    Hi Jim,
    I am in a similar situation (Low or Zero Tax Rate) but at a different stage of my life than the example you have provided. I am currently retired and have no earned income. My wife works part-time and brings in about $12K per year before taxes. Our only other income is dividends and capital gains. All told, when we take our income, subtract from it our itemized deductions and personal exemptions we would end up owing no tax. So what I have started to do and plan on continuing until I turn 70 (I am 59 right now) is a partial Roth Conversion. Currently my total portfolio has about 75% in IRA accounts, 18% in Taxable accounts and 7% in Roth Accounts. I will be converting about $50K per year to keep me in the 15% tax bracket and hopefully after 10 years I will have a more balanced ratio of IRA to Roth IRA monies.

    1. jblankenshipNo Gravatar says:

      Sounds like a great plan, John! I actually cover a similar situation in the article which will come out on Friday, except that we’re working with someone hoping to minimize or eliminate taxation of Social Security. Watch for the article!

      jb