Roth IRA Conversion – A Multi-Year Strategy

With all of the buzz about Roth IRA conversions this year as a result of the elimination of the $100,000 modified adjusted gross income threshold for converting traditional IRA’s to Roth IRA’s, clients and non-clients alike have been asking me the million-dollar question, “Should I do a Roth IRA conversion?” The underlying implied question usually is, “Should I convert 100% of my traditional IRA to a Roth IRA this year?”

Despite the media frenzy and the associated rush to do Roth IRA conversions in 2010 to obtain the alleged benefit of recognition of 50% of the income from the conversion in 2011 and 50% in 2012, a Roth IRA conversion, if it makes sense, doesn’t have to be, and in most cases shouldn’t be, a one-time event. Unless you meet the criteria of one or more of the four ideal candidates presented in The Ideal Roth IRA Conversion Candidate – Parts 1 and 2, you should be using a multi-year strategy for your Roth IRA conversions. Even if you’re an “ideal candidate,” it still may make sense to defer a portion of your conversion to 2011 and later years.

One of my clients, Mr. and Mrs. Retired, meet the criteria of Ideal Candidate #1 presented in the February 8th blog, The Ideal Roth IRA Conversion Candidate – Part 1, i.e., no current income tax liability without any tax losses. Mr. and Mrs. R. are both less than 70-1/2, are taking distributions from nonretirement accounts, a large portion of which are nontaxable or tax-favored, and their itemized deductions and personal exemptions offset whatever otherwise taxable income they have so that they aren’t subject to any income tax liability. Mr. R. retired at the end of 2006.

A substantial portion of Mr. and Mrs. R.’s investment assets are in retirement accounts, including traditional IRA’s and Roth IRA’s that have been converted from traditional IRA’s over the last three years since Mr. R. retired. Even though their tax situation is such that they aren’t incurring any income tax liability, it didn’t make sense to convert 100% of Mr. and Mrs. R’s traditional IRA’s to Roth IRA’s in 2007, the year after Mr. R. retired, nor did it make sense to do this over three years since Mr. and Mrs. R. would incur income tax liability they would otherwise not incur.

The strategy that I’m using with Mr. and Mrs. R. has been to prepare one or more income tax projections each year to determine the optimal amount of traditional IRA’s that can be converted to Roth IRA’s without incurring any income tax liability. This is tricky since the conversion amount is limited by the inclusion of a portion of Mr. R.’s Social Security benefits in income that wouldn’t otherwise be includible without the conversion. This strategy has resulted in the successful conversions of $30,000 to $60,000 a year, or a total of $140,000 over the last three years, without any associated income tax liability. We will continue to employ this strategy over the next several years to convert the remainder of Mr. and Mrs. R.’s traditional IRA’s to Roth IRA’s without recognizing any income tax liability.

The next time you ask your financial advisor, “Should I do a Roth IRA conversion?,” you might want to add to the end of the question, “…this year or over the next several years?”

By Robert Klein

Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.