End of Year Roth Conversion Strategy: Fill Up the Bracket

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If you’re in a relatively low tax bracket and have funds in a traditional IRA or Qualified Retirement Plan, chances are you might be in a position to set yourself up with tax-free income via a Roth Conversion.  One method that can work in your favor is the “fill up the bracket” technique, and if you want to do this for 2011, you’re running out of time, it must be done by December 30 (December 31 is a Saturday).

The way this works is that you determine what your regular income is, and then look at where you are with regard to your tax bracket.  If there’s still some “headroom” in the current bracket, you could convert an amount, equal to or less than your “headroom”, from your traditional IRA to a Roth IRA.  This way you are controlling the tax rate at which your conversion occurs, keeping it in the lower tax bracket.  By doing this, you are reducing the value of your traditional IRA and therefore the size of your future Required Minimum Distributions (RMDs) while increasing the amount you have in Roth IRA accounts for future tax-free growth.

Well that was clear as mud, right?  Let’s work through an example.

Fill Up the Brackets Example

Let’s say your taxable income (before any conversion) is $50,000.  This puts you in the 15% tax bracket, and (for 2011) this leaves $19,000 of headroom in the bracket, up to $69,000 in taxable income for a married couple filing jointly.  Given these facts, you could convert as much as $19,000 from your traditional IRA, assuring that you’d only pay 15% on the additional income – assuming that the increase in ordinary income doesn’t have an adverse impact on your deductions and/or credits.

If you did this over the course of several years, it could significantly reduce the balance in your traditional IRA, thereby reducing the amount of your future Required Minimum Distributions (RMDs) from the traditional IRA(s).  Then you’d have significant money set aside in the Roth account which could grow tax-free for the rest of your life.

Additional Concerns

Of course, as with all Roth conversions you need to project into the future what your tax rate will likely be in order to make sure this is a proper move.  If your projected future tax rate will be equal to or more than the bracket you’re in today, then the Roth Conversion makes sense.  This requires you to make assumptions about the future tax rates, and so if you’re pessimistic (realistic?) you’ll assume that the rates in the future will increase.

Generally, unless you expect your income to decrease in the near future, it might work best to convert at least small amounts now, paying the tax when you have the ability.  This will provide you the option of controlling (at least somewhat) your tax burden in the future.  Every person’s situation is going to be different, and as such there is no rule of thumb to determine if the conversion makes sense for you.

One way that this could work in your favor is if you’ve been let go from your job early in the year, thereby reducing your overall income for this tax year.  If this happens you might be in a much lower tax bracket than you normally would be, providing you with lower tax bracket headroom in order to employ this tactic.

One other thing you need to keep in mind with this tactic (and all IRA distribution tactics, including all Roth Conversions) is the tax impact to your Social Security benefits (if you’re receiving them currently).  If your nominal income is low enough to allow for less than the full 85% taxation of your Social Security benefits, recognizing additional income via a Roth Conversion could bump you up over the limit.  This would cause additional income from the Social Security benefit to be taxed, increasing your tax hit on the conversion as well.