In your traditional IRA account you purchase 1,000 shares of Widgets.com. You originally paid $10/share for a total investment of $10,000. After your purchase, you watch the stock decline to $4/share. Bummer. All of your research indicates that Widgets.com is a really strong company. The fundamentals and financials are both good, but the stock is out of favor at the moment, or has been unfairly punished with the decline of other dot-com companies. You believe the stock will not only come back to its original level, but will flourish in the future. Your computations indicate the stock should be worth $30/share in about five years. What are your options?
Well, you can hold on to the shares in your IRA account. Or, you can sell the shares and take the loss, remembering that this loss would not be deductible for tax purposes because the trading took place within your IRA account. Not only that, you don't want to sell. You see tremendous upside potential for the company and the stock.
How about a conversion to a Roth IRA account?
You would simply transfer the 1,000 shares from your traditional IRA account to a Roth IRA account. It matters not if you don't currently have an existing Roth IRA. If you meet the income qualifications (modified adjusted gross income of $100,000 or less), you can still make a conversion from your traditional IRA account to a Roth IRA account.
So, you make the transfer. The fair market value (FMV) of the shares at the time of the conversion is $4/share. Therefore, you have conversion income of $4,000. If you're in the 28% bracket, you'll pay about $1,120 in federal taxes on this conversion. Owch. But if you really believe in the stock and your research supports your belief, you'll find this to be a small price to pay.
After some time, let's say that Widgets.com becomes the darling of Wall Street. You watch as the price moves from $4/share to your projected valuation of $30/share. The investment in your Roth IRA account now has an FMV of $30,000. And, the beauty of it is that, as long as you follow the Roth IRA distribution rules, the entire $30,000 can be taken tax-free after you reach age 59 1/2. So, in effect, you paid $1,120 for tax-free income of $30,000. Not a bad trade off, eh?
If you had left these shares in your traditional IRA account, somebody (either you or your beneficiaries) would pay taxes on the entire $30,000. Assuming you and your beneficiaries are all in the 28% bracket, a tax of about $8,400 would be due on the $30,000 distribution from a traditional IRA account.
You might think that this gambit only works when you're near the qualified distribution age of 59 1/2. Not true. Even if you were only 30 years old when you made the original conversion, imagine how you'll be able to "grow" this $30,000 over the next 29 1/2 years, all tax-free.
As many of you will remember, if you made a conversion from your traditional IRA to a Roth IRA in 1998, you were allowed to spread the conversion income over a four-year period. Since 1998 is long behind us, many folks have decided not to make a conversion to a Roth IRA because all of the conversion income is immediately taxable. But remember that the conversion from your traditional IRA to a Roth IRA is not an "all-or-nothing" situation.
Consider Lana, who has $100,000 in her traditional IRA account. There is nothing to prohibit her from making small transfers over a number of years -- $10,000 a year for 10 years, $5,000 a year for 20 years, or something like that. By creating her own spread out of conversion income, Lana controls the tax that she'll pay on the conversion in any given year.
If she converted the entire $100,000 all in one year, it might throw her into a higher tax bracket. Even if it didn't, it would certainly affect those deductions and other issues related to her adjusted gross income (such as medical expenses, phase-out of itemized deductions, miscellaneous deductions, phase-out of personal exemptions, tax on Social Security benefits, etc.), but making the conversion in smaller chunks might allow Lana to avoid those tax traps.
Sure, it'll cost her some conversion tax dollars each year, but the potential tax-free pay off could be enormous. And, not only that, cleaning out the traditional IRA will allow Lana to eliminate (or at least greatly reduce) the minimum required distributions that must be taken at age 70 1/2. Why? Because, as you'll recall, there are no minimum distribution requirements from your Roth IRA account.
So, be creative when dealing with conversions from a traditional IRA to a Roth IRA. There aren't many times that you can convert otherwise taxable income into potentially tax-free income. Enjoy the experience.