If you are still licking wounds inflicted by this year's volatile stock market, a Roth conversion might be the healing balm you are seeking as 2015 draws to a close.
Converting assets from a traditional IRA to a Roth is worth considering in any year as a way to diversify retirement holdings for tax purposes. But the case for conversion—also known as a backdoor Roth—is more compelling than usual this year for investors holding IRA investments that have declined in value. Any amounts you convert are taxed as ordinary income, and a diminished asset generates less tax liability—or allows you to convert larger sums.
Roth IRAs accept only post-tax dollars, and generally, distributions are tax-free on accounts open at least five years, assuming the distribution is made after age 59-1/2. Contributions can be withdrawn at any time (earnings and assets converted from traditional IRAs are subject to the usual IRA penalty rules).
Contributing directly to a Roth is almost a no-brainer for young retirement savers, who tend to be in lower tax brackets and will benefit most from years of tax-free investing.
However, contributions are subject to the same annual limits as traditional IRAs ($5,500 in 2015 and 2016, or $6,500 for savers age 50 or older). Direct Roth contribution are also phased out for higher-income workers.
Conversions, on the other hand, spark a pay-now or pay-later question. They make the most sense for older retirement investors who tend to be in higher tax brackets. "A market decline alone doesn't mean you should do a conversion," cautions Tim Steffen, director of financial planning at Robert W. Baird & Co. "But in the right situation, it does make conversion less expensive."
As retirement approaches, a strong case can be made for diversifying your holdings between tax-deferred and post-tax accounts. Most people assume they will be in a lower tax bracket after 70. But leaving everything in a tax-deferred IRA or 401(k) actually can push you into a higher tax bracket in retirement because of required minimum distributions (RMDs), which begin at age 70-1/2. RMDs are not required with a Roth.
At the same time, reducing the value of your tax-deferred holdings will reduce your required RMDs from those accounts.
"Diversifying your holdings really gives you a lot of flexibility to be as tax-efficient as possible in retirement," said Maria Bruno, senior investment analyst with Vanguard Investment Strategy Group.
Do it right
A particular sweet spot for conversions are people who may no longer be working, but have not yet filed for Social Security, and therefore may be in lower tax brackets, Bruno said.
If squeezing in a 2015 Roth conversion before the Dec. 31 deadline appeals to you, here are some tips for doing it right:
Do not convert unless you can fund the tax liability with assets outside your IRA.
Using IRA assets to pay taxes and fees makes it difficult to come out ahead in the long run, research from Robert W. Baird & Co. shows.
"You need to get as much inside the Roth as possible to let it grow tax free," Steffen said.
Also remember that if you are younger than age 59-1/2, you will pay an additional 10% penalty on top of the tax.
Consider a partial conversion that "fills up" your current tax bracket.
Going just up to the limit of your current bracket will help to minimize your tax liability.
Keep in mind you always have the option of a "do-over" in 2016 if the conversion decision looks less attractive later.
If you convert $50,000 in mutual fund assets to a Roth before the end of 2015, but by March 2016 the fund's value falls to $40,000 - you might want a "recharacterization."
The recharacterization period begins on the day of conversion and is open through the due date of your tax return for that year. But you can use extensions to push it to October 15th of the year following the year of conversion. (The rules on recharacterization are somewhat complex, so consult with your tax adviser.)