Investors facing the Roth-conversion decision tend to see it as an either/or proposition: keep everything in the traditional IRA, or convert everything into a Roth.
But there’s a third option: leaving some money in the traditional IRA while converting the rest.
The most obvious reason would be to prevent the conversion from kicking you into a higher tax bracket. Income tax must be paid on deductible contributions and investment gains, and these sums are added to your taxable income. If converting everything would boost you from a 15% to 25% tax bracket, it could make sense to limit the conversion so you can keep the lower tax rate.
Many people doing that plan a sequence of conversions over several years until everything is moved into the Roth.
But it may be worth thinking about leaving some of your funds in the traditional IRA for good, to hedge against the uncertainty over future tax rates.
Generally, a Roth conversion makes sense if you expect to be in a higher tax bracket in retirement, since you could pay tax at today’s lower rate to avoid a bigger tax later. But if you expect your tax rate to fall, you’d pay less by sticking with the traditional IRA and paying at the lower rate when you make withdrawals later.
The problem is that, even if you can predict the size of your taxable income in retirement, no one knows what the tax laws will be in five, 10, 20 or 30 years. In the worst case, Washington could change the rules to give you a higher tax rate even if your income goes down.
By keeping some funds in the traditional IRA and converting the rest, you could have a bit more control over your future tax situation. The result won’t be quite as good as if you guessed correctly about your future tax bracket, but it won’t be as bad as it would if you guessed wrong.
Upon turning 70 ½, you would have to start required minimum distributions from your traditional IRA, even if you did not need the money. But RMDs are not as terrible as many people think. A person with a life expectancy of 20 years would have to withdraw only 5% of the traditional IRA assets that year. Obviously, you’re not required to spend that withdrawal, only to pay taxes on it.
If you needed more than the required minimum to live on, you could consider taxes when deciding whether to draw from the traditional IRA or the Roth. Using the Roth would be better if your tax bracket were high, or if drawing on the traditional IRA would kick you into a higher bracket. Drawing from the traditional IRA would make sense when your bracket was low.
A savvy retiree would also factor in tax implications of withdrawing from ordinary taxable accounts. In some years, you may be able to sell money-losing investments to offset the taxes you’d otherwise owe on money taken from a traditional IRA.
Use the Roth IRA Conversion Calculator to figure whether a conversion makes sense. Also check the conversion advice offered by your stock broker and mutual fund company. Charles Schwab (Stock Quote: SCHW) and T. Rowe Price (Stock Quote: TROW) offer detailed discussions.