Fine-Tune Your Roth Conversion the Easy Way

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With all you've been hearing about converting your traditional retirement accounts to a Roth IRA, you might get the sense that the right thing to do is to convert every penny you have saved for retirement. In reality, though, deciding how much to convert is at least as tricky a decision as whether to convert in the first place.

3 ideas on how much to convert
To guide you in this decision, let me throw out three ideas for thinking about how much to convert. Your goals include:

  • Using up low-rate tax brackets
  • Focusing on converting high-return investments
  • Keeping everything affordable

Each of these methods will get you thinking in a different way about your retirement accounts and what to do with them.

Tax brackets and you
The biggest factor in whether to do a Roth conversion is whether your current tax rate is lower than what you'll pay after you retire. Since you can't know for sure what your tax rate will be when you need the money, what you'll pay now is the only certain quantity.

If you have a lot of taxable income right now, that's a strong argument against converting. If your income is low right now, though, it might be a perfect time to use a Roth conversion to take advantage of those low rates -- but if you convert everything at once, you may end up paying more in taxes than you have to.

Personally, I believe that if you're in the 15% tax bracket or lower, converting enough to use up that low bracket is a no-brainer for most people. So for instance, if you can increase your taxable income by $25,000 and still pay taxes at 15%, then you'd convert up to $25,000 this year, saving any additional amounts for future years.

Higher tax brackets require more thought. Currently, the next bracket up is 25%, and while it's entirely possible that you'll pay higher taxes than that when you retire, it's also a lot more likely you'd pay the same or a lower rate. At that point, the other factors below might play a bigger role in helping you decide how much to convert.

Converting big winners
Another way of thinking about converting involves your asset allocation. The Roth IRA is best suited for the investments you expect to grow the most, so getting high-growth investments into a Roth gets you the biggest tax-free benefit possible.

In practical terms, that means:

  • Convert the money you have allocated to small-cap growth stocks -- those with the same characteristics that helped stocks like Green Mountain Coffee Roasters (Nasdaq: GMCR  ) , Hansen Natural (Nasdaq: HANS  ) , and Intuitive Surgical (Nasdaq: ISRG  ) soar in the past.
  • Keep money allocated to conservative stocks like Johnson & Johnson (NYSE: JNJ  ) , Wal-Mart (NYSE: WMT  ) , and IBM (NYSE: IBM  ) in a traditional IRA. You don't expect them to grow as quickly, so they aren't as high a priority for tax-free treatment.

Stocks that fall somewhere in between -- perhaps a large-cap growth stock like Apple (Nasdaq: AAPL  ) , for instance -- could go either way, depending on the other factors. But they should be a lower priority than your maximum-growth prospects.

Now remember, just because I list those stocks as examples doesn't mean you should buy them for your Roth. The key is to find tomorrow's winners, not yesterday's top performers. If you think your past winners will keep soaring, great. But don't chase performance and expect lightning to strike twice.

Stick with what you can afford
Lastly, remember that you'll have to pay tax on whatever you convert, and ideally, you'd like to pay that tax from assets outside your IRA. If you have a lot of cash available, that's not a factor, but for most people, it's something to consider.

Bear in mind that in 2010, you have a special option that lets you spread out the tax impact of your conversion over the 2011 and 2012 tax years. That makes the calculations even more complicated, and your eventual tax bill even harder to predict, but it may make it possible for you to convert a larger amount than you'd otherwise be able to.

Don't panic
If all this sounds complicated, that's because it is. These are all just general rules of thumb, and applying them to your particular situation is tricky. But remember that the recharacterization rules give you a lot of latitude to correct mistakes later on. And in all likelihood, you'll be able to keep converting gradually in future years if you want.

Of course, the obvious next question is what to do with your Roth after you've converted. Tomorrow, I'll close this week-long look by examining the best investments for your Roth IRA.

If you have questions or comments about Roth IRAs, pipe up in the comment section below. Dan can't give specific investment advice, but general questions can help others in a similar situation.

Fool contributor Dan Caplinger spent two hours fine-tuning the sound and video delay when he first got Rock Band for his PlayStation. He doesn't own shares of the companies mentioned in this article. Wal-Mart is a Motley Fool Inside Value pick. Green Mountain Coffee Roasters, Hansen Natural, and Intuitive Surgical are Motley Fool Rule Breakers recommendations. Apple is a Motley Fool Stock Advisor pick. Johnson & Johnson is a Motley Fool Income Investor recommendation. The Fool owns shares of Intuitive Surgical. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is razor-sharp and always in focus.

Read/Post Comments (10) | Recommend This Article (10)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 07, 2010, at 1:01 PM, BoomerBull wrote:

    Question: Since I will have a carryover loss from my 2009 tax return exceeding $3000 (which is the max that can be applied to income), can I use that loss against a $3000 conversion to Roth, thus requiring no additional tax on the conversion?

  • Report this Comment On January 07, 2010, at 2:12 PM, foolishfollies wrote:

    If Social security buckles, and has to "restructure". One of the benefits SAM might institute for those adversely affected is to limit or eliminate taxes on money saved in Private savings accounts.

    This is one scenerio that would make it more advantageous to stay in tax deferred vehicle.

    Very hypothetical and very speculative theory, but my theory non the less. Have a nice day.

  • Report this Comment On January 07, 2010, at 3:22 PM, TMFGalagan wrote:

    @BoomerBull -

    No, Roth conversions are treated as ordinary income rather than capital gains, and thus you can't use conversion income to offset capital losses beyond the typical $3,000 limit.


    dan (TMF Galagan)

  • Report this Comment On January 07, 2010, at 10:45 PM, theboo1 wrote:

    I am interested in converting some traditional IRA monies into Roth this year as I have lost my job so my income this year should be much lower. I am planning on spreading the taxes over 2 years. I am 60 and currently have $161,000 in a Roth account. I have $218,000 in my traditional IRA with additional $65,0000 in 3M stock. Any suggestions on the amount to convert? I was planning on using the 3M stock to pay taxes on the conversion.

  • Report this Comment On January 08, 2010, at 10:32 AM, lwtomcat wrote:

    Regarding a traditional IRA, if I sell a stock within the account how are taxes handled? I thought I wasn't taxed until I withdraw from the account? Does it hurt me if I sell before holding the stock for more than a year?



  • Report this Comment On January 08, 2010, at 8:05 PM, Innkeeper15 wrote:

    I am 62. I have close to one million in an individual IRA. I want to move some to a Roth.

    Is it true, when you convert to a Roth you cannot get any of the earnings out for 5 years? You can get the original principle out minus the taxes you paid. This is even if you are over 59 and a half.

    If I convert a large sum, will I be a high income earner since it is taxed as earnings, hence disqualify me for a Roth?

    You raise more questions than you answer.

  • Report this Comment On January 08, 2010, at 8:10 PM, Innkeeper15 wrote:

    I am 62 and I have one million in a traditional IRA.

    Is it true if I convert to a Roth, I cannot withdraw any of the earnings for 5 years even though I am over 59 1/2?

    If I convert a large amount, will I be classified as a high income earner since the funds are taxed as normal earned income? Will this disqualify me for a Roth?

    You column raises more questions than answers.

  • Report this Comment On January 08, 2010, at 8:43 PM, dafka wrote:

    When I did the conversion of a traditional IRA to Roth IRA in 2009, I didn’t look at how that conversion might impact the taxation of our Social Security income. I have now discovered that 85% of our SS benefits will be taxed for 2009. In 2008, our income was so low that we had not been required to pay any taxes on our SS benefits.

    Just one more factor to consider.

  • Report this Comment On January 09, 2010, at 10:48 PM, BorealHobbit wrote:

    I am 57. I rolled a 401K worth ~$300K into an IRA consisting of Gold Coins in November 2008. It has appreciated to ~$500K. If I convert it to a Roth 1) will I have to pay capital gains taxes on top of income tax? 2) If I pay the taxes from within the IRA, will that cause me to be subject to an early withdrawal penalty?

  • Report this Comment On January 13, 2010, at 10:21 PM, boger1 wrote:


    You won't be classified as anything in terms of the Roth. The point of the law is that people of ANY income can make the conversion starting 2010.

    Not sure about the 59 1/2 vs 5 year earnings rule. I am not close to withdrawing or being 59 1/2, so I haven't paid attention. Straightforward question for any CPA though. My thought is that once you have converted to the Roth, ALL of the conversion is considered "contributions" (original principal) because you have already been TAXED on it. So all of it should be eligible for withdrawal.

    Try looking at the calculators available at T Rowe Price, Vanguard and others. For those close to retirement (within 10 years) the conversion makes less and less sense unless you are doing it for estate-planning (to save money for heirs) or simply do not want to take RMDs at any cost.

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