Ask an expert whether you should convert a traditional IRA into a Roth IRA and you’ll hear a lot about tax brackets. A conversion is more likely to make sense if you expect to be in a higher bracket in retirement than you are now.
But there’s another tax-bracket issue to consider: What would a conversion do to your tax rate in the year you do it? If it would lift your bracket much higher — from 15% to 25%, for example — it could pay to spread the conversion over two or more years to stay in the lower bracket.
Income tax must be paid on taxable portions of money converted from a traditional, tax-deferred IRA, just as if you were making a withdrawal in retirement. The taxable portions are investment gains plus original contributions that were tax deductible.
If you’d made $5,000 in deductible contributions and $7,000 in non-deductible contributions, and the account had grown to $30,000, the taxable amount would be $23,000. You would not have to pay tax on the $7,000 non-deductible contribution because that money had already been taxed.
If you converted the entire account in 2010, you’d add $23,000 to your taxable income. That could easily lift you into a higher tax bracket.
Fortunately, the same law that lifted the income test determining who is eligible to convert also provides for people who convert in 2010 to divide the tax bill evenly over 2011 and 2012. If you chose that option, a conversion done in 2010 would add nothing to your tax bill for that year, but it would add $11,500 to your taxable income in each of the following years.
Complicated enough? Wait, there’s another twist. If you have more than one traditional IRA, you have to blend them together to figure the taxable portion of the converted amount, even if you only convert money from one account. This is done by adding together the value of all the accounts and figuring what percentage of the total is taxable.