Let’s first review what you need to know to make this decision. To begin, you need to understand what your current marginal tax bracket is and how the amount of income tax that you pay is calculated by the IRS. The “marginal” tax bracket is your highest tax rate. In other words, each of us gets the benefit of the lowest tax brackets, but your “marginal” tax bracket is the highest tax rate that you will pay. The question to consider is If you received another $1 of ordinary income, how much tax would you pay on it?
For example, consider a single female who earns $75,000 per year. She contributes $3,000 to her employer’s 401(k) plan and has no dependents. She has mortgage interest of $12,000 and property tax of $3,000, and makes charitable contributions of $3,500. What is her “marginal” bracket and how does this influence if she should convert part of her IRA to a Roth IRA?
First, take her $75,000 salary and subtract the $3,000 of 401(k) contributions; you get an Adjusted Gross Income (AGI) of $72,000. Because her “itemized deductions” exceed the standard deduction for individuals in 2014 ($6,200), she will be able to subtract $12,000 of mortgage interest plus $3,000 of property tax plus charitable contributions of $3,500. Her total itemized deductions are therefore $18,500. For 2014, she can subtract another $3,950, which is her personal exemption. Her taxable income, which is the value that the IRS uses to calculate her tax owed, comes to $49,550 (AGI minus itemized deductions minus personal exemption). Using the IRS tax tables for those filing Single, she see that on the first $9,075 of taxable income in 2014, she pays 10%; on the next $27,825 of income she pays 15%, and then, on the next $16,600 of taxable income, she pays 25%. Therefore, she is in the 25% “marginal” bracket, even though she gets to use the lower tax brackets for a lot of her income, up to $36,900.
So…if you consider converting part of your IRA to a Roth IRA, that means that in the year that you convert, you will be adding the amount that you convert to your taxable income. For example, if you decide to convert $10,000 of your IRA to a Roth IRA in 2014, and the above facts are accurate….you will be paying 25% or $2,500 in additional income tax to be able to move that $10,000 to a Roth IRA. Do you really want to do that?
If you think you’ll be in a lower tax bracket (ex. 15%) when you retire, it may not make sense to move that money and pay 25% in tax now, when you would only pay 15% on the distributions when you retire. However, maybe it will make more sense to convert if you are in a lower tax bracket – you retired early and you no longer have a salary. Or if you have a significant business loss, or if your itemized deductions go way up due to medical expenses, etc.
Even if you have a third party tax preparer, I encourage you to take the time to understand your income tax calculation. We all pour over receipts when we purchase goods and services for accuracy to make sure the addition and charges are correct. Our income tax bill is a very significant expense that we are all paying. Understanding and checking the accuracy of your tax bill is being a good steward and may help you consider additional deductions that you had not considered. No one cares more about your tax bill than you!
Here is a link to a calculator that can help you determine the costs/benefits of converting a part of your IRA to a Roth IRA: