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The floodgates have opened for high-income investors who were previously forbidden from converting to a Roth IRA. But now that everyone has the opportunity to reap the benefits of these tax-free retirement accounts, you have to ask yourself: Are the costs of converting really worth paying?
Throughout the week, I've given some reasons why converting to a Roth might not make much sense. If you expect that your tax rate will drop once you retire, then paying taxes now, at a higher rate, can cost more than you'd gain by converting. Moreover, older investors who don't have a long enough time horizon to get the full benefit of a Roth might not want to take the risks involved.
There's another reason why you might want to think twice about a Roth conversion. Although you may be prepared to pay tax on the amount you convert, you might not be aware that converting could also cost you some other unrelated tax benefits.
Income and your taxes
Once upon a time, income tax returns were short and sweet. Pretty much all you had to know was your income, and calculating your tax liability was simple.
Now, though, tax returns are a minefield of income, deductions, credits, and calculations, all of which interact with each other. A change in one seemingly unrelated area -- like making a Roth conversion -- can have a ripple effect that can raise your tax bill in unexpected ways.
For instance, many deductions and credits are pegged to your taxable income. In other words, if you make too much money, you may no longer be eligible for a certain deduction or credit. Here's just a few of the tax benefits that you can have taken away if your income is too high:
- For the popular First-Time Homebuyers' Credit, which is worth as much as $8,000 to qualified taxpayers buying a home, two different limits apply. If you bought your home on or before Nov. 6, 2009, then the credit completely phases out for single taxpayers with adjusted gross income (AGI) above $95,000, or married taxpayers with AGI above $175,000. After Nov. 6, those limits increase to $145,000 for singles and $245,000 for couples.
- To take the American Opportunity Credit, which is worth as much as $2,500 toward qualified education expenses, the maximum AGI is $90,000 for single taxpayers and $180,000 for couples.
- Under certain circumstances, having higher income can make money you get from Social Security taxable. The calculations are complicated, but in general, if you add half your Social Security benefits to your other income, and the resulting total is more than $34,000 for singles or $44,000 for couples, you could have as much as 85% of your benefits taxed.
What does all this have to do with a Roth conversion? Well, when you convert, you increase your taxable income. Not only will you pay taxes on that extra amount, but you could also push your income so high that you miss out on benefits like the ones above.
Trim down your tax bite
You can do several things to try to offset the impact of a Roth conversion, including:
- Reducing dividend income. If you have high-yielding dividend stocks like AT&T (NYSE: T ) , Altria Group (NYSE: MO ) , or Verizon (NYSE: VZ ) in taxable accounts, getting them into your Roth can help you cut your income. For every $10,000 you own in these stocks, making a move could reduce your income by $600 or more.
- Holding onto winners. If you have huge paper gains on big movers like Apple (Nasdaq: AAPL ) or Ford (NYSE: F ) in a taxable account, you might be tempted to sell them and take profits. If you wait, though, you'll keep your taxable income lower -- and perhaps still qualify for those valuable tax benefits.
- Dumping losing investments. Similarly, if you have losing stocks like Time Warner Cable (NYSE: TWC ) or Valero Energy (NYSE: VLO ) in your portfolio, you might be waiting for them to rebound. By selling them now, though, you can claim as much as $3,000 in losses against ordinary income -- which could help you claw back some of the benefits you lose to a Roth conversion.
Still, those moves might not reduce your income enough to make a big difference. If that's the case, you might be better off waiting to convert until your income is lower, or you no longer qualify for benefits like education credits or the credit for first-time homebuyers.
Tomorrow, I'll close out this series with a look at one final thing to keep in mind when deciding whether to convert to a Roth: whether you plan to spend your money during retirement, or leave it as a legacy to someone else.