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.
