Path to converting savings to Roth IRAs is full of 'ifs'
I've read so many surveys about people neglecting to save for retirement that my eyes hurt.
Although the research highlights a simple truth - you have to save for your retirement - how are you supposed to do right when the tax rules are so darn complicated?
For example, I recently wrote about a change in the tax code allowing high earners to convert their traditional IRAs and other similar workplace retirement-saving vehicles to Roth IRAs. There is much appeal to having a Roth, because unlike traditional IRAs, withdrawals are not taxed. It's a good tax strategy for many.
But "there are a lot of nuances to conversion," says Chris McDermott, senior vice president for investor education, retirement and financial planning for Fidelity Investments.
I would use the word "maddening." Still, people who are heeding the advice to save and invest so they won't have to completely rely on the government in their old age must try to understand the rules. So I expected and received some questions about Roth conversions. To help answer them, I turned to McDermott.
Can the amount of my Roth rollover propel me into a higher tax bracket?
The quick answer is yes. But the full answer depends on how much of your traditional IRA you are converting.
First, here's a little background. On Jan. 1, the income limits for converting traditional 401 (k) or other workplace savings plans to a Roth IRA were removed. Previously, you could not switch from a traditional IRA to a Roth if your modified adjusted gross income on your federal income tax return was more than $100,000.
The rule change opened a back door for high-income earners who had previously been shut out of Roth conversions. But (and there is always a "but" with this stuff) if you are converting funds to a Roth, you have to pay income tax on the pretax contributions and earnings that are converted. The amount of tax is based on your tax bracket in the year you convert. Therefore, the amount you convert, which becomes taxable income, can push you into a higher tax bracket.
It's not easy figuring out how the conversion will affect your tax bracket because you might not know which bracket you are in until you get all your year-end tax information. Here's another nuance: If you convert this year, you can include half of the conversion amount on your 2011 return and the other half on your 2012 return. But keep in mind that you could end up in a higher tax bracket during this time - therefore, your tax liability might be higher than if you had paid it all at once.
My advice, as I wrote before, is to get help from a tax professional familiar with the rules of a Roth conversion.
Why shouldn't I use money from my traditional IRA to pay the taxes?