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Save Taxes With a Roth Conversion

November 23rd, 2007 at 11:12 am

As 2007 comes to a close, now is the time to decide on strategies that can save on taxes, either now or in the future.

If 2007 has been a year in which your income is lower than your normal income and if you will have significant “Schedule A” income tax deductions, you may want to consider converting some of your traditional IRA funds to a Roth IRA .

Using your 2006 tax return as a guide, determine your approximate 2007 income. Reduce your income by contributions made to your Health Savings Account, IRA contributions, self employed health insurance and 1/2 of any self employment taxes paid. The remainder will be your approximate Adjusted Gross Income (AGI) for 2007.

If your AGI is over $100,000, you are not eligible to make a Roth conversion in 2007.

If your AGI is under $100,000, determine what your approximate “Schedule A” itemized tax deductions will be in 2007. Schedule A includes home mortgage payments, medical expenses, charitable gifts and state and local taxes plus any property taxes.

Your next step is calculate exemptions by multiplying your total number of claimed dependents (including yourself) by $3,400.

Subtract both your approximate Schedule A deductions (or the Standard Deduction, if that is greater) and your exemptions from your estimated 2007 AGI. The remainder is your approximate 2007 taxable income.

As a single filer, subtract your taxable income from $31,850. The remainder is the approximate amount of your IRA holding that you can convert to a Roth IRA at a 15% tax rate.

As a joint tax filer, subtract your taxable income from $63,700. This is the approximate amount that you can convert to a Roth IRA at a 15% tax rate.

Once you have converted IRA funds, they will grow tax free until they are withdrawn. When they are withdrawn, the withdrawals will also be totally tax free. The small amount of taxes that you pay now will keep you from paying significantly more in taxes when you retire.

There is one caveat. This approach should only be used if you have adequate non-IRA savings to pay for the increased taxable amount. However, if you are able to pay the increased taxes, your long term tax savings can be significant.

2007 Roth IRA conversions must occur before December 31, 2007. If this approach may be appropriate for you, do your homework now, so the conversion can be completed before the end of the year.

3 Responses to “Save Taxes With a Roth Conversion”

  1. monkeymama Says:

    & don't forget the $100k cap on AGI is lifted in 2010. Which means you can convert in 2010, regardless of income. (You can even spread out the taxes over 2-3 years I hear. Those details I haven't researched yet).

    We converted all of our IRAs over 2 years, because we dropped to a lower tax bracket. Which is sweet considering we are only paying 15% tax on IRAs we got a 25% tax deduction for in prior years.

    Of course, decades of tax-free growth is why we decided to switch. Much more lucrative than the current tax trade-offs.

  2. finabguide Says:

    Well said!

    Decades of tax free growth combined with the fact that if you have anything left for your heirs and pass on the Roth funds, they can get more decades of tax free growth.

    If you are able to pay the taxes, and are in the 15% tax bracket (or less), I believe that converting IRA funds to Roth IRA funds is your basic "no-brainer."

  3. Broken Arrow Says:

    I've nothing to add other than to chime in that I agree it's a great idea... and that when the time comes, that's what I'll be doing (and to pay the taxes with my savings rather than from the retirement fund)!

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