Roth IRA conversion during early retirement

Many people convert their Traditional IRAs to Roth IRAs due to the favorable tax treatment given to Roth IRAs. Under current law, money held in a Roth IRA is completely free from all future federal and state taxes. This is especially attractive if you believe that you will be in a high tax bracket during retirement, or if you expect the tax rates to go up in the future. You pay tax during the conversion process, in effect trading current tax payments for a reduction in future tax liability.

There is one group of people for whom Roth conversions are especially attractive -- early retirees who are living off the savings in their taxable accounts. This is especially true if you plan to retire abroad. Since your income is likely to be lower during early retirement years, it would be an ideal time to convert your Traditional IRAs to Roth IRAs. If planned properly, this can save a considerable amount in overall taxes.

What if your retirement savings are not in an IRA, but in another type of tax-deferred account like a 401(k) or a 403(b)? No problem -- these accounts can rolled over to a Traditional IRA using a direct rollover, and then converted to Roth.

What if your IRA was funded with non-deductible contributions? In this case, Roth conversion is even more attractive, since the portion of the converted amount that comes from nondeductible contributions is not taxed during the conversion. You will only be taxed on the earnings and on any deductible portion in your IRA.

Here are some more details about the Roth conversion process:

  • Although usually described as a "conversion", what really happens is a rollover. You are transferring money from one account to another account, usually held with the same custodian.
  • Currently, you may convert from a traditional IRA to a Roth IRA if your AGI (Adjusted Gross Income) is less than $100,000. The same limit applies to both single filers and married filers filing jointly.
  • Even the $100K income limit for converting to a Roth IRA will disappear in 2010, thanks to Tax Increase Prevention and Reconciliation Act (TIPRA) signed into law in May 2006. Unless the law is changed again, Roth conversions will then be available to all.
  • The 10% penalty for an early withdrawal from an IRA account does not apply to Roth conversions, so the conversion can be done at any age.
  • Taxes for Roth conversion are calculated by adding the converted amount to your AGI for the year in which the conversion was done, and then calculating your taxes using regular tax tables.
  • If you are living and working abroad when you do a Roth conversion, your income earned overseas will qualify for foreign earned income exclusion. For 2007, up to $82,400 can be excluded from AGI. However, due to changes introduced in TIPRA, your tax bracket may be higher than they used to be in previous years, so you need to be careful about attempting a Roth conversion.
  • The conversion can be spread out over several years (i.e., doing a partial conversion each year) so that you stay in a low enough tax bracket, taking into account your other taxable income for each year.
  • If you have multiple IRA accounts, you get to choose which ones to convert first (and whether to convert at all). For most people, the account with the most growth potential should be converted first. There are more aggressive strategies available for handling this decision, however.
  • Once the IRA has been converted, you will have to wait 5 years before the converted amount can be withdrawn penalty-free. Otherwise a 10% penalty will apply, unless you are over age 59.5.

For an extreme example, consider a retired couple living abroad with only $12,000 in taxable interest income in 2007, and taking the standard deduction.

They can deduct the standard deduction and personal exemptions from the AGI to calculate their taxable income. The 2007 standard deduction for a married couple filing jointly is $10,700 and personal exemptions are $3,400 each. So they will only owe tax on the amount by which their AGI exceeds $17,500 (= 10,700+3,400+3,400).

According to the 2007 tax schedule for a married couple filing jointly, they will be in the 10% federal bracket till their taxable income is $15,650, and in the $15% federal bracket till their taxable income is $63,700. This means that they can convert up to $5,500 (= 17,500-12,000) to a Roth IRA tax-free, another $15,650 at 10% tax rate, and up to $48,050 (=63,700-15,650) more at a 15% rate.

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S. B. said...

This is a good article about an important topic for early retirees. I think I will write a follow-up article and post it to my blog later tonight.