martin said:
Hello. I'm 30 years old. Recently returned to grad school, so for
2007 my annual income will only be $8,400. Since I'm in the lower tax
bracket now, I thought it would be a good idea to convert my
Traditional IRA to a ROTH IRA since the tax penalty won't be as bad.
I have $18,000 in the IRA.
Do I understand this correctly, that $18,000 + $8,400 = $26,400 will
be what determines my tax bracket, which will determine the tax
penalty I pay for the ROTH conversion? Or will the $18,000 in the IRA
be taxed at a capital gains or some other rate?
There would be no tax "penalty" on the conversion (as in 10% early
distribution penalty), only ordinary tax, as previously noted.
You have the choice to convert less than 100% of the traditional IRA
balance in any given year. From a financial planning viewpoint, be sure
to take into account the following for 2008 and beyond (as mentioned,
you're too late for 2007).
1. With an AGI (adjusted gross income) of only $8,400, you would
typically owe no federal tax. You might want to convert only the amount
that takes you to the top of the 10% tax bracket, but not into 15%. For
single, no dependents, that amount is calculated as $8,950 (std
deduction + exemption) plus $8,025 (taxable income in 10% bracket), or
$16,975 total AGI. If you convert more, then the additional amount will
be taxed at 15%. Even this rate may be good for you, however, if this
is the last year for a long time that you will be below 25% tax bracket
(which is likely once you graduate and go back to work full time).
2. It's recommended to have a source of funds other than the IRA itself
to pay the tax on the converted amount, otherwise the amount withheld
from the conversion to pay the tax *will* be subject to 10% penalty.
3. You don't state how much of your income is from earnings and how much
from investment or other sources, but you might be eligible for the
Earned Income Credit. Raising your AGI by converting "too much" of your
IRA might lose you some or all of this refundable credit.
4. As a student, you might have other education-related tax benefits
that are either gained or lost as you raise your (modified) AGI, thereby
affecting your overall "effective" tax rate.
5. Although the point of an IRA is to save money for retirement, one
side effect of converting to a Roth is that after five years, the
converted amount can be withdrawn with no penalty and no additional tax
even if you are nowhere near retirement age, thereby allowing it to be
part of your emergency fund or other financial requirements (beyond just
tax implications).
If you use tax software, you can create multiple "what if" scenarios for
2008 by using the 2007 software (just mentally adjust all the dates used
by one year). Or, the storefront tax preparation firms will gladly give
you a free consultation on this in the hope of getting your business.
-Mark Bole
