Using Systematic Partial Roth IRA Conversions and Recharacterizations
Roth IRAs have been a popular way to generate future tax-free growth and income since their creation. Yet the decision to contribute or convert to a Roth IRA incurs an immediate tax liability that could become so heavy as to be destructive. So writes Michael Kitces in “Using Systematic Partial Roth IRA Conversions and Recharacterizations To Fill The Lower Tax Bracket Buckets,” his Dec. 2 entry
in his blog, Nerd’s Eye View.
But the decision to do a Roth conversion doesn’t have to be “all or none,” Kitces says. In fact, he argues, not only is a “partial” Roth conversion permitted, in practice it could be the best strategy.
Not only that, Kitces says, the Roth recharacterization rules make it feasible to precisely fill the bottom tax brackets. How? He says that is accomplished by converting more than enough to fill those brackets each year, and then doing a partial recharacterization to make the best possible partial Roth conversion at the start of the new year.
Kitces says that while the Roth conversion rules are often discussed as though an entire IRA or other pre-tax retirement account might be converted, it is really the case that under Internal Revenue Code Section 408A(d)(3) whatever dollar amounts are distributed to a pre-tax IRA and rolled into a Roth will be treated as taxable as a Roth conversion. “There’s no minimum or maximum regarding how much
must be converted. In other words, a Roth conversion doesn’t have to be all or none; it’s up to the investor/taxpayer to decide whether to convert everything, or to simply do a ‘partial Roth conversion’ instead,” says Kitces.
The fundamental point, Kitces argues, is that Roth conversions really don’t have to be an all-or-none transaction, and can be done as a partial Roth conversion on a prospective basis or partially recharacterized after the fact to create the same result. “In practice, doing a partial Roth conversion — or rather, a series of them — is often the best way to maximize the long-term value of a pre-tax retirement account!” he writes.
Ultimately, Kitces says, “the goal of partial Roth conversions is to find a balance, where the converted amount is low enough to avoid top tax rates today, but not so little that the remaining retirement account balance plus compounding growth causes it to be exposed to top tax brackets in the future, either.”
There are some caveats, Kitces notes. For one, it remains necessary to determine the ideal tax bracket, or amount of income, to partially convert to a Roth in the first place. Also, he says, it is important to keep in mind that Roth conversions themselves will affect future tax rates.
The bottom line, Kitces says, “is simply this: the availability of low tax brackets is an opportunity that should be utilized before it is lost, and the partial Roth conversion (or a Roth conversion followed by a partial recharacterization) is a flexible strategy to ensure that those low tax rate buckets never go to waste!”