Converting a traditional IRA to a Roth IRA can be expensive in tax consequences, especially if the transaction kicks you into a higher tax bracket. One way to control your tax bite is by converting only a part of your IRA assets. With a long-enough time window, you can eventually convert your entire IRA through a year-by-year series of partial conversions.
Any IRA-to-Roth conversion will be charged against your taxes in the year you make the conversion. Although you have until April 15 of the following year -- the tax-filing deadline -- to make IRA contributions, any conversion must be completed by December 31.
You are allowed any number of conversion transactions during the year. The taxable amount for each conversion will be the value of the assets on the date of transfer. Even if you make a conversion early in the year, you still can tailor a conversion late in the year to match your tax situation.
If you decide to undo -- or recharacterize -- all or part of your conversion, multiple transactions can greatly complicate the process, because you must calculate investment performance of the entire account in figuring the recharacterization amount. This gets increasingly tricky if you are blending new and existing Roth assets. Generally, the calculation starts with the value of the account on the date of the conversion and ends with the value of the account on the date of the recharacterization. Multiple conversions will require you to factor in additional start dates in your investment performance calculations. If you think you might recharacterize all or part of your conversion, putting each transaction into a separate Roth IRA account will simplify your recharacterization tax liability calculations. You can easily combine the accounts after your recharacterization deadline -- which is the date you file your taxes -- has passed.
A recharacterization makes sense if the value of your Roth IRA decreased markedly after your partial conversion. At least you won't pay tax on value that's no longer in your Roth. But the IRS makes it difficult to send money back and reconvert it immediately with a lower tax bill. Any money recharacterized can't be reconverted in the same year as the original conversion or within 30 days of the recharacterization. Two examples: If you convert in January and recharacterize in June, you must wait until the following January 1 to redo your conversion. If you wait until your tax-filing deadline to recharacterize, you must wait 30 days to process another conversion.
The IRS provides a way around the reconversion obstacles. You're allowed to segregate assets in separate IRA accounts for conversion purposes. Because you made a partial IRA conversion, you left behind assets in one or more IRA accounts. To avoid blending your IRA assets, send the recharacterized Roth money to a new IRA account, and you can immediately convert IRA assets not involved in the original conversion.
- Internal Revenue Service: Publication 590 Individual Retirement Arrangements (IRAs)
- Tax Guide for Investors; Partial Conversion; Kaye A. Thomas; January, 2008
- Tax Guide for Investors; Roth IRA Reconversion to Reduce Taxes; Kaye A. Thomas; January, 2008
- Tax Guide for Investors; Recharacterization Blues; Kaye A. Thomas; February, 2009