*Break up over a few years conversions to keep taxes lower:
Early retirees who are living off taxable accounts and not working generate very little income tax when you take into account their exemptions and standard deduction. Making an IRA-to-Roth conversion in this instance subjects it to the lower tax brackets. If you have a very large amount to convert, break it up and convert it all over 2 or 3 years to keep it in the lower tax brackets.
As an example, assume a retired couple's income consists only of $15,500 in taxable interest income in 2012. But they'll incur no taxable income until their AGI exceeds their personal exemptions and standard deduction. For 2012 the standard deduction for a married couple filing jointly is $11,900 and their personal exemptions are $3,800 each. So until their income exceeds $19,500 (= 11,900+3,800+3,800), they have no 'taxable' income. The can sustain another $4,000 in income and still pay no tax.
For 'married filing jointly' (for 2012), the lowest two tax brackets - 10% and 15% - cover the first $70,700 of taxable income and produce $9735 of tax. So that'll be the least taxation for converting $70,700 from an IRA to a Roth if all of it was subject to the tax brackets and there's no other taxable income.
For our couple above, they already have $5,000 leftover for tax free income before they're subject to the tax brackets. So they can convert $75,700 (= $5,000 + $70,700) of their IRA to a Roth IRA at a tax expense of only $9735. That's under 14% effective tax on their $75,700 conversion.
Over just 3 years they could convert over $227,100 of an IRA to a Roth for under $30,000 in taxes if they can maintain their tax status. You can see that if you can lower your other taxable income, you can make those conversions cheap.
Don't forget that if you've made nondeductible contributions to a traditional IRA, then those contributions - not the earnings they generated - can be converted to a Roth IRA without taxation. That's because without the deduction, you already paid income tax on them in the year you contributed.
So, stretch out your conversion of your IRA to a Roth IRA over a few years at least. The eventual tax savings both for yourself and your beneficiary can be quite substantial.
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Shane Flait helps you with your financial legal, tax, and retirement goals.
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