One of my favorite uses of the Roth IRA is to turn a year or two of low income into an opportunity to save enormous amounts of income tax (and possibly estate tax). Let's say that you've just ended your employment, either voluntarily or involuntarily, either temporarily or permanently. Most likely, you have some tax-sheltered savings. It might be in the form of traditional IRAs, employer-based programs such as 401(k) or 403(b) plans, or even your own plan from self-employment such as a Keogh or SEP-IRA. Or it might include all 3.
Now, sooner or later, somebody is going to have to pay income taxes on all deductible contributions and earnings that have accumulated in these plans. Why not choose a year of unemployment to do it? I'm not suggesting taking money out of these plans to spend right now. After all, if you aren't 59 1/2, such a choice might lead to taxes AND penalties, and even if you can do so without penalty, the idea isn't to spend the money now, but to help build your assets for the long run.
A partial or total Roth conversion might be the smartest thing to do. Any traditional IRA can be converted to a Roth IRA as long as the taxpayer's modified adjusted gross income is under $100,000 before taking the conversion into account (this income restriction will be eliminated in 2010), and while there will be income taxes owed on the converted amounts (except to the extent they represent non-deductible contributions previously made), if the year is one with little or no other income, the tax cost might be minimal (or even $0). Here are three different situations where I've recommended their use to people I know:
(1) A retired widow owned some rental properties, and major repairs following a vacancy caused her to have one year with negative taxable income ... before taking my advice. At my urging, she converted a $25,000 traditional IRA to a Roth IRA that year, and even after adding that income to her return, she ended up having a total tax bill of only about $1,000. Most of it was not taxable at all, since it only brought taxable income up from the large negative number to zero, $7,000 was taxed at only 10%, and the remaining couple thousand at 15%. In later years, when normal conditions gave her much higher income, all of her IRA distributions would have been taxed at 15% or higher, but now that converted IRA and all future earnings from the Roth account will be tax-free. A side benefit is that the mandatory withdrawals from the old IRA are gone, and in future years these withdrawals would have had the effect of raising her provisional income for purposes of calculating the taxable portion of social security benefits: her effective tax rate on the withdrawals would actually have been 22.5% after taking into account this side issue. But now it won't be a problem, since Roth distributions are neither required nor, when made, included in the provisional income calculation.
(2) A couple that had hit it big with an Internet company wanted to make a mid-career correction. I encouraged them to leave their jobs in late December and not start their next until the January 13 months later. This created a year with no income outside of a small quantity of dividends, and we converted all their retirement accounts to Roth IRAs during that empty year. As a result of their normal personal and dependent exemptions and a tax credit for tuition (one of them decided to return to school for a master degree), they were able to convert all their tax-sheltered savings with no taxes at all. The year before, they had been in a combined 40% + federal & state tax rate, and in future years they were likely to return to something similar, but by using that one year, they saved themselves enormous quantities of taxes, permanently.
(3) A client is close to retiring from his current business and plans to live off accumulated wealth while pursuing work that will be extremely fulfilling but not profitable. I'm encouraging him to make the maximum contribution to his Keogh plan each year ($40,000+), getting a tax deduction in his top bracket. When he closes the business and the income disappears, we will convert enough to Roths each year to take full advantage of the 0%, 10%, and 15% tax brackets. Should he later start making significant money in the new profession (not likely), we can stop doing so, so that none of those assets end up being taxed at higher rates.
These are just a few examples. There are a few considerations here:
(A) Only a traditional IRA can be directly converted to a Roth IRA. Other plans must first be transferred to a traditional IRA before then being converted (this is more of a formality than anything, but still must be obeyed).
(B) It is not necessary to convert everything: you may choose to convert only a portion to a Roth IRA. The decision will usually be based on the desire to take advantage of lower brackets and avoid having converted money taxed at higher ones.
(C) The conversion must take place during the calendar year: unlike contributions, which can often be delayed until April 15 of the following year or later, conversions always apply to the year they take place.
(D) Since you don't actually know your annual income until the year ends, you can convert during the year and then change your mind and UNCONVERT (the actual term used is recharacterize) a part or all before your tax return is due. In fact, you have until October 15 of the year following the conversion to recharacterize the converted amount. So you might do a conversion in January 2006, expecting it to be a good year for such a conversion, and then recharacterize as late as October 2007 if that isn't the case, either because of higher than expected 2006 income or a major drop in the market after the conversion (since all converted amounts are taxed, except for non-deductible contributions, it is best to do so when the market is at the bottom). So if you do some converting in January 2006, and the market drops afterwards, you can reverse the original conversion and do another one at a lower value instead.
There are some complications and limitations and it is important to be aware of all tax issues when using this strategy. And tax laws change. Modesty prevents me from mentioning one of many knowledgeable tax professionals who can assist you with implementing this strategy. You can also read about it yourself: a superb book on the Roth IRA is THE FAIRMARK GUIDE TO THE ROTH IRA by Kaye A. Thomas.
