In most years it makes sense to tap a traditional IRA to withdraw money at a tax rate of 15 percent or 25 percent, as long as you can avoid a 10 percent early withdrawal penalty. If you’re married and file a joint return with $100,000 of taxable income in 2010, for instance, you could withdraw up to $37,500 from your IRA and owe only 25 percent in tax.
This year, though, there’s no reason to withdraw if you don’t need the money now. Instead, you can convert the same amount of money to a Roth IRA to use up the lower bracket. By doing so, you’ll get the benefit of staying in the low tax bracket brackets but still keep your money inside a retirement plan. With a Roth IRA, all withdrawals can be tax-free after five years and after age 59 1/2.
Exception: The only person for whom this strategy–converting a traditional IRA to a Roth IRA to use up a low tax bracket–would not make sense is someone who is under age 59 1/2 and who expects to withdraw funds within five years, while still under age 59 1/2. Such a person would face a 10 percent penalty for such a post-conversion withdrawal.
Suppose Harry Larson converts a $37,500 traditional IRA to a Roth IRA in 2010 to fully use up his 25 percent tax bracket. Harry is 53 years old. He would have to report $37,500 of taxable income in 2010 from the conversion. If Harry withdraws $10,000 from the account in 2014, when he is 57 years old, he would owe a 10 percent penalty tax on the $10,000 withdrawal: $1,000.
