Ha is right, this IS complex. I spent a couple of hours this afternoon studying different scenarios. I came up with the following rules and guidelines. Please tell me if you see any mistakes. Hopefully this will be helpful to others, but I'm doing it for my own benefit since this will be my strategy unless someone finds flaws with it.
Sorry if I don't explain this clearly. If someone has looked at conversion and the 15% bracket closely, hopefully they'll understand what I'm talking about. If someone hasn't looked at this before, you should definitely plug in your own numbers into a tax program to see for yourself.
The top of 15% bracket is $34K (single). For couples, use $68K. This is the 2010 numbers and it will change.
Dividends & Long Term Cap Gains for someone in the 15% bracket are 0%, if you keep your TOTAL income in the 15% bracket, including Divs and LTCG. In many places I just call this dividends, but I mean both. Also, this only refers to qualified dividends. Non-qualified dividends count as income.
Roth IRA converted money is Income.
The $34K limit is after deductions and credits. Standard deduction in 2010 is $5700 ($11400 if married, 2010 numbers). If you itemize it could be more. Don't forget to use this when pushing to the top of the 15% bracket.
After $34K (top of 15% bracket) COMBINED income/conversion + div/LTCG, every new dollar converted is taxed @ 15%, PLUS a dollar of dividends is moved from free to taxable at 15% up to another $34K or totals divs/LTCG, whichever is smaller.
So for example, if you have $14K in income after deductions and $20K in dividends, you pay up to 15% on the $14K income (there is some in the 10% bracket) and 0% on dividends.
But if you have $20K in income, you pay up to 15% on that income, plus 15% on $6K of dividends. $14k of dividends remain untaxed. So by converting $6K over the 15% bracket, that 6K was taxed @15% plus you moved $6K in dividends in to taxable @ 15%.
Another way to view: In the first $34K (top of 15% bracket), dividends are FREE. After that, each dollar of income (Roth IRA conversion) is taxed at 15%. Every dollar converted also moves a dollar to 15% tax, so essentially a 30% tax on each dollar converted over this limit.
Once income (without dividends/LTCG) hits $34K, all dividends are now taxed @ 15%, so there is no additional 15% hit because you aren't pushing any more dividends from 0% to 15%. Income is now in the 25% bracket, but there is no additional penalty of pushing divs/LTCG into taxable income, so the tax rate drops from 30% to 25% on the extra dollar. Seems surprising but I really think this is true from looking at how the Qualified Dividends and Capital Gains Worksheet calculations are done.
So, for example, if you have $34K in income, and $20K in dividends, you pay up to 15% on the $34K income and 15% on the 20K divs.
If you have $84K in income, you pay 25% on that extra $50K, and still just pay 15% on the divs.
If you have a large IRA, when minimum required distributions hit at 70.5, you may be crossing the 15% line if you don’t convert at all. This is an important consideration. Since again, once you cross the 15% line, you are pushing dividends from 0% to 15%, effectively pushing your tax rate to 30% for dollars beyond that until all divs are taxed.
BOTTOMLINE:
1. Always convert just up to the 15% cap (unless income in later years will stay in the 10% bracket)
2. The goal should be to have income up to the 15% cap in every year rather than convert any money when it will be taxed above 15%. Keep this in mind when talking about the next points.
3. If for some reason, income alone will hit the 15% cap, it is probably worth converting all the way to the 28% level because that is better than paying 30% in later years if you cross the 15% line with MRDs. However, the more you convert, the less the IRA MRD, so the less likely you’ll cross the 15% line. See next item, which is related to the previous item
4. If dividends alone are pushing you to the 15% cap every year, the effective rate on any conversion or MRD is 30%, so, it is better to convert at 25% and 28% when you have an opportunity those years where you already have some income. But, if dividends are lower, it’s ok to leave some IRA to distribute in later years if you can still stay under 15%.
An example of point 4 is that I'll be working a partial year next year, so I'll already be close to the top of the 15% bracket on income alone. So, it seems it would be good to convert a large chunk, all the way up to the end of the 28% bracket because that's better than paying at the 30% rate later.
Other considerations:
- Income producing stocks and bonds should be in your Roth IRA and traditional IRA as much as possible, to give you more room to convert and stay in the 15% bracket.
- Using tax-exempt rather than taxable bonds will also help keep you in the 15% bracket, but see if the reduced return on tax-exempt bonds is worth it.
Factors I haven't taken into account:
- tax rates could go up or down--more likely up unless a VAT becomes the preferred method of increasing tax revenue. Also, I don't think the 15% class will be hit too hard with taxes.
- inflation could more easily push one above the 15% tax rate if the brackets rise slower than inflation. This implies that you should tend to convert now where it seems to make sense.
- taxation on dividends and cap gains may change, so this will have to be adjusted then. Most likely the change will be for the worse, like taxing them at regular income rates, which again implies you should convert now where things seem otherwise even.
