Lower Taxes and Tax Free Income with Roth IRA Conversions

Holding investments inside a Roth IRA forever frees the future gains on these investments from taxation - whether the gains are capital gains, interest or dividends. The investments inside a Roth IRA will never be taxed again! In addition, you will not be forced to make required minimum distributions from your Roth IRA when you turn 70 1/2 years old. These are powerful, long-term wealth building characteristics unique to Roth IRAs. Because of these factors, each year (along with your financial advisor and CPA) you should take a serious look at whether or not you can benefit from converting some of your traditional IRA investments to Roth IRA investments.

Times to Consider Making a Roth IRA Conversion

• You had a large loss on a rental property that you just sold which will result in a significantly lower income tax bracket for this year.
• You were laid off from work or decided to change jobs on your own and you will temporarily be in a lower tax bracket.
• You retired early thus dropping into a lower tax bracket temporarily. However, you will jump back to a higher tax bracket once you turn age 70 1/2 and are forced to make withdrawals from your IRA accounts.
• You received a significant inheritance and for a time can withdraw less money from your traditional IRA accounts; thus dropping you into a lower tax bracket temporarily.
• You plan to make a significant charitable gift that will drop you into a lower tax bracket.
• You are getting toward the end of your life and have significantly more than enough money to live on and are in a low tax bracket - but your kids are all in a high tax bracket.

As you can see, the idea here is to never let a lower tax bracket go unused. If you are going to be in a lower tax bracket for whatever reason, convert enough traditional IRA investments to a Roth IRA to use up the lower tax brackets.

What is Roth IRA Recharacterization?

The nice thing about Roth IRA conversions is that they can be reversed or adjusted at anytime before you file your tax return the following year. If you file an extension, this means you have until October 15th of the following year to reverse your Roth IRA conversion. This is called Roth IRA recharacterization.

Because Roth IRA conversions are reversible, some people take the extra step of making a Roth IRA conversion with fixed income investments in one account and a second conversion with stock investments in another account. They do this even though they only intend to keep one of these Roth IRA conversion accounts.

If the stock market drops significantly, the stock conversion account will be recharacterized and the fixed income conversion account will be kept. If the stock market rises, the stock conversion account will be kept and the fixed income conversion account will be recharacterized. This way, they only keep (and pay taxes on) the conversion that has significantly appreciated in value.

If you don’t want to bother with this more complicated approach, at least convert a balanced mix of stocks and bonds so you will not be too hurt by a significant stock market correction after making your conversion.

Make looking for Roth IRA conversion opportunities part of your annual financial and tax planning process.