Why you might want to consider a partial conversion of your traditional IRA to a Roth IRA.
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The word conversion seems to imply that your old IRA remains in place and is now treated as a Roth IRA, and that makes it sound like you can’t do a partial conversion. After all, how can an IRA be partly a traditional IRA and partly a Roth IRA?
In reality, conversion is just a convenient word for the process that moves assets from a traditional account to a Roth IRA. You can convert part of a traditional IRA, ending up with some of your money in both types of accounts.
When to do a partial conversion
Many people will find that if a conversion makes sense, the best choice is a full conversion. But a partial conversion can be helpful in some circumstances.
- Tax brackets. A full conversion may cause you to report enough income to push you into a higher tax bracket. That may not be a big deal, especially if you’re moving from the 22% bracket to the 24% bracket. But if you’re moving from the 12% bracket to the 22% bracket, that’s a pretty big jump to swallow. You should understand that only the portion of your taxable income that falls into the higher bracket will be subject to the higher rate. You won’t pay a higher tax on all of your income merely because it pushes up into the next bracket. Still, in some cases it will make sense to limit your rollover to the amount that you can fit within your current tax bracket, especially if you’re looking at the difference between the 12% bracket and the 22% bracket.
- Cash available to pay tax. You may have cash available outside your retirement account to pay tax on a partial conversion, but not enough to pay tax on a full conversion. If you’re under 59½ and you have to use some of your IRA money to pay tax on the conversion, you could end up paying a 10% early distribution tax. Before you pull the trigger, figure out how much tax you can handle without dipping into IRA assets and then figure out how much you can convert for that amount of tax.
- Tax diversification. Some financial advisors like the idea of maintaining more than one type of account so that you can have a choice of which one to use in later circumstances — and so you won’t have as much regret if your conversion turns out to be a bad idea due to unexpected developments.
How to do a partial conversion
Your IRA provider should be able to provide any help you need to do a partial conversion. You’ll need to tell the provider how much of your IRA you want to convert. If your IRA contains different types of assets, you’ll have to indicate which ones to move. For example, if your IRA is split between two mutual funds, you may choose to move one fund or the other to the Roth IRA, or move part of each.
Consequences of a partial conversion
If all of your contributions to your traditional IRA were deductible (or were rollovers of pre-tax dollars from employer plans such as 401k plans), your partial conversion is fully taxable. The taxable amount is determined as of the date of the conversion. For example, if you transfer XYZ stock on December 15, the value of XYZ stock on that day will determine the amount of income you report from the partial conversion.
If you made nondeductible contributions to a traditional IRA at any time in the past, and haven’t previously withdrawn the nondeductible contributions, then your partial conversion will be partly nontaxable. The rules that apply here are the same as for any distribution from a traditional IRA. You treat all traditional IRAs as a single IRA, so you don’t get a different result depending on which IRA you convert. You add up the total value of all traditional IRAs and also the total amount of nondeductible contributions to those IRAs to determine what percentage of the conversion amount is taxable. For example, if 60% of your IRA balance comes from nondeductible contributions and you convert $8,000 of that IRA, you’ll report $3,200 of income from the conversion (40% of $8,000).
Can you convert just the nontaxable portion? See Isolating Basis for a Roth Conversion.