Why backdoor Roths look more attractive this year

If you are still licking wounds inflicted by this year’s volatile stock market, a Roth conversion might be the healing balm you are seeking as 2015 draws to a close.

Converting assets from a traditional IRA to a Roth is worth considering in any year as a way to diversify retirement holdings for tax purposes. But the case for conversion – also known as a backdoor Roth – is more compelling than usual this year for investors holding IRA investments that have declined in value. Any amounts you convert are taxed as ordinary income, and a diminished asset generates less tax liability – or allows you to convert larger sums.

Roth IRAs accept only post-tax dollars, and generally, distributions are tax-free on accounts open at least five years, assuming the distribution is made after age 59-1/2. Contributions can be withdrawn at any time (earnings and assets converted from traditional IRAs are subject to the usual IRA penalty rules).

Contributing directly to a Roth is almost a no-brainer for young retirement savers, who tend to be in lower tax brackets and will benefit most from years of tax-free investing.

However, contributions are subject to the same annual limits as traditional IRAs ($5,500 in 2015 and 2016, or $6,500 for savers age 50 or older). Direct Roth contribution are also phased out for higher-income workers. A full contribution can be made only up to $183,000 in modified adjusted gross income for joint filing households, and $116,000 for single filers (a reduced contribution can be made up to $193,000 for joint filers and $131,000 for single filers).

Conversions, on the other hand, spark a pay-now or pay-later question. They make the most sense for older retirement investors who tend to be in higher tax brackets.

As retirement approaches, a strong case can be made for diversifying your holdings between tax-deferred and post-tax accounts. Most people assume they will be in a lower tax bracket after 70. But leaving everything in a tax-deferred IRA or 401(k) actually can push you into a higher tax bracket in retirement because of required minimum distributions (RMDs), which begin at age 70-1/2. RMDs are not required with a Roth. At the same time, reducing the value of your tax-deferred holdings will reduce your required RMDs from those accounts.

Learn more at Reuters Money.

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