Help me with the tax implications of converting my traditional IRA to a Roth

[ShuShu1971]

Hello Mustachians! I have been lurking on this board for awhile, but this is my first time to post. I am interested in converting my husband's and my traditional IRAs to Roths, and I suspect this year may be a good time because our income has dropped. Can you help me understand exactly how this works, so that I don't create unintended tax consequences next year?

Here are the details:

My husband and I both worked for a company which was bought out in 2013. Each of us moved our traditional 401ks to traditional IRAs at that time. My husband has continued to work for the new company and grosses $61,000 a year. I left the new company last August and have stayed at home since. We are now in the 15% tax bracket.

I read in another thread that there is a 0% tax liability on dividends and capital gains in the 15% tax bracket. Does that mean that we could convert the full amount of our traditional IRAs to Roths with no tax consequence?

Is the entire balance (currently $350,000 combined) considered dividends and capital gains, or is there some portion which is still taxable?

Could we convert the full amount in one year, or are we limited to the amount which is the difference between our AGI and the top end of the 15% bracket ($73,000 or whatever it is)?

Also, does it matter that I changed our investment options at the end of 2014? When I look up our accounts at Vanguard, our gains are shown as short-term gains. Must I keep the money in place for one year before I make the conversion?

Thank you for your help!

[Gone Fishing]

Anything converted or withdrawn from the IRA would be taxed as regular income.  We can help you come up with a bit of tax strategy with the following information:

Current ages
When your husband intends to retire
How much you have in other investments and what types
Any expected pension or other income in retirement

[forummm]

The amount you convert is taxed at normal income tax rates--not dividends and capital gains.

Only the amount you convert is taxed in that tax year.

[Cromacster]

See above, any conversion is considered income, which you will pay taxes on.

At this point in time I see no real reason to convert it.  Unless you feel that taxes in your future are going to be much higher than they currently are now.

[ShuShu1971]

The anything converted or withdrawn from the IRA would be taxed as regular income.  We can help you come up with a bit of tax strategy with the following information:

Current ages
When your husband intends to retire
How much you have in other investments and what types
Any expected pension or other income in retirement

I am 43. He is 46. I am at home with our son for the time being, but I suspect that I will someday work at least part time again. My husband enjoys working and does not necessarily plan to retire early; however, if by handling our money wisely and intentionally, that was an option at some point, all the better.
The $350k in traditional IRAs is the bulk of our retirement money. We have an additional $65k or so already in Roths and approximately $5k in the new company's 401k. We also have a small HSA containing about $6k. Savings outside of tax-advantaged accounts is negligible.

[Gone Fishing]

Great, one more question, what is your current saving/spending out of that $61k?

[ShuShu1971]

Great, one more question, what is your current saving/spending out of that $61k?

That is tricky to answer and will depend somewhat on what life throws at us. We are natural savers, and have had years when we saved nearly 20% toward retirement alone. This reduced income is new to us, however, and we have had some recent surprise demands on our budget, so I will conservatively say at least 10% will go toward retirement. About $40k a year goes toward a combination of our day-to-day expenses and saving up for future day-to-day expenses (replacing a car, future home repair, etc.) We carry no debt except for the mortage, $78k.

[nereo]

Great, one more question, what is your current saving/spending out of that $61k?

That is tricky to answer and will depend somewhat on what life throws at us. We are natural savers, and have had years when we saved nearly 20% toward retirement alone. This reduced income is new to us, however, and we have had some recent surprise demands on our budget, so I will conservatively say at least 10% will go toward retirement. About $40k a year goes toward a combination of our day-to-day expenses and saving up for future day-to-day expenses (replacing a car, future home repair, etc.) We carry no debt except for the mortage, $78k.

If this is the case, it's almost certain that a more beneficial use of your money would be to increase the savings in your tax-advantaged accounts (instead of paying the taxes for converting funds from a tIRA to a ROTH).  You and your spouse can save up to $11,000 into tIRAs, and chances are you have the ability to use either a 401(k), 403(b) or other account.

[ShuShu1971]

Great, one more question, what is your current saving/spending out of that $61k?

That is tricky to answer and will depend somewhat on what life throws at us. We are natural savers, and have had years when we saved nearly 20% toward retirement alone. This reduced income is new to us, however, and we have had some recent surprise demands on our budget, so I will conservatively say at least 10% will go toward retirement. About $40k a year goes toward a combination of our day-to-day expenses and saving up for future day-to-day expenses (replacing a car, future home repair, etc.) We carry no debt except for the mortage, $78k.

If this is the case, it's almost certain that a more beneficial use of your money would be to increase the savings in your tax-advantaged accounts (instead of paying the taxes for converting funds from a tIRA to a ROTH).  You and your spouse can save up to $11,000 into tIRAs, and chances are you have the ability to use either a 401(k), 403(b) or other account.

Ok, that's what I was looking for ... the most beneficial use of our money. Thank you!

[Gone Fishing]

Sounds like your husband is on track for a pretty traditional retirement age (60-65) based on your current savings.  As far as any conversions go, I'd probably leave everything pretty much alone.  Your tax rates will probably be pretty similar in retirement as they are today.  The time for a conversion is when your income is very low, but if all goes to plan, you probably won't have a big drop off in income like someone who is retiring under 55 or someone with a very volatile income.  The one exception is if the market takes a massive hit.  If you can stomach paying out extra in taxes during the depth of a recession, it might be worth converting a portion of the account each year while staying out of the 25% bracket.     

[nereo]

That is tricky to answer and will depend somewhat on what life throws at us. We are natural savers, and have had years when we saved nearly 20% toward retirement alone. This reduced income is new to us, however, and we have had some recent surprise demands on our budget, so I will conservatively say at least 10% will go toward retirement. About $40k a year goes toward a combination of our day-to-day expenses and saving up for future day-to-day expenses (replacing a car, future home repair, etc.) We carry no debt except for the mortage, $78k.

After I responded i left my desk and ate lunch, and gradually realized that there were some alarm bells ringing in the background.  To be clear, saving up for future 'day-to-day' expenses can't be considered part of your savings rate unless you also count spending that money later as part of your expenses. 
For example, let's say you are saving up to buy a gently used car
Year 1: save $5,000
Year 2: save $5,000
Year 3: save $5,000
Year 4: spend $15,000 on the car, save nothing that year
average savings-per-year = $0.

It's great to plan for future expenses, but that's all part of your spending, not your saving.

Regarding my earlier comment - I think you've got it.  Putting more money into tax-advantaged accounts will help you far more than trying to do any conversion.  Let's say you and your spouse make $78k next year.  If you converted $10k from a tIRA to a ROTH it would be taxed as your last-dollar-made, in this case 25%.  So you'd pay $2,500 to convert and have $10k in savings.  A better method is simply to put that $2,500 towards tax-advantaged accounts, giving you $12,500 in savings.  When you go to withdraw that money in retirement you will be taxed on it (and taxed on a first-dollar-out basis), but you will almost certainly pay less than 25% on that money unless tax codes drastically change.

[ShuShu1971]

That is tricky to answer and will depend somewhat on what life throws at us. We are natural savers, and have had years when we saved nearly 20% toward retirement alone. This reduced income is new to us, however, and we have had some recent surprise demands on our budget, so I will conservatively say at least 10% will go toward retirement. About $40k a year goes toward a combination of our day-to-day expenses and saving up for future day-to-day expenses (replacing a car, future home repair, etc.) We carry no debt except for the mortage, $78k.

After I responded i left my desk and ate lunch, and gradually realized that there were some alarm bells ringing in the background.  To be clear, saving up for future 'day-to-day' expenses can't be considered part of your savings rate unless you also count spending that money later as part of your expenses. 
For example, let's say you are saving up to buy a gently used car
Year 1: save $5,000
Year 2: save $5,000
Year 3: save $5,000
Year 4: spend $15,000 on the car, save nothing that year
average savings-per-year = $0.

It's great to plan for future expenses, but that's all part of your spending, not your saving.

Regarding my earlier comment - I think you've got it.  Putting more money into tax-advantaged accounts will help you far more than trying to do any conversion.  Let's say you and your spouse make $78k next year.  If you converted $10k from a tIRA to a ROTH it would be taxed as your last-dollar-made, in this case 25%.  So you'd pay $2,500 to convert and have $10k in savings.  A better method is simply to put that $2,500 towards tax-advantaged accounts, giving you $12,500 in savings.  When you go to withdraw that money in retirement you will be taxed on it (and taxed on a first-dollar-out basis), but you will almost certainly pay less than 25% on that money unless tax codes drastically change.

Yes, we are on the same page. As we save up for the next car, etc., I think of that as "spending," not "saving." We will still probably save a minimum of 10% toward retirement going forward, and would love to have that number be higher, but will have to see how things go.