Should we convert to a Roth IRA? Look at big picture on taxes

Q: My husband and I are thinking about converting our traditional IRA to a Roth IRA, but we aren’t sure if it’s right for us. We are both (he will be 65 and I'll be 67) retired and receive pensions, although I did continue to work one-half of 2015. We haven’t applied for Social Security yet; we haven’t had a need for it yet. I don’t think file and suspend will for us because of my husband’s pension. So, I'm leaning toward starting collecting Social Security by April to rebuild our savings. We have about $300,000 in traditional IRAs and roughly $10,000 in a Roth IRA. We also have several thousand dollars in stocks, bonds and mutual funds in a taxable account. We've just relocated to Georgia and spent quite a bit of our saving to do renovations and the like. What do you think? Also, my husband would like us to do a reverse mortgage; we have no mortgage. — Brigitte Kelley,Milledgeville, Ga.

A: Most of the standard answers to the question — to convert or not — tend to focus on your future tax rate. If it’s higher, convert. And if it’s the same or lower, don’t convert

But there’s much that must go into the decision to convert your traditional IRA into a Roth IRA than your future tax rate, according to Joseph Clark, a managing partner with The Financial Enhancement Group in Anderson, Ind. “The conversation is much deeper than a simple yes or no,” he says.

Whether a Roth IRA conversion is right for you is based on several personal financial factors.

The first is maximizing your marginal tax bracket. “You must think about every line on your 1040 as a symphony where you may not be able to hear the individual instruments but you can surely hear the music,” says Clark. “When one instrument makes a mistake they are quickly identifiable. The same is true on your 1040.  Each line works in concert with the rest so no decision — including a Roth conversion — should take place without understanding the implications.”

That said, if you find yourself in the 10% or 15% marginal bracket with room to do a conversion of $10,000 or more at that marginal rate, Clark says it’s usually worth the effort to complete the conversion.

The second type of conversion is more opportunistic and is based on three underlying factors, he says.

1. Do you have the cash flow to pay the taxes on the conversion? “It almost never makes sense to use IRA money to pay the taxes to do the conversion,” Clark says.
2. How much are you willing to convert based on your anticipated marginal tax rate including the conversion?

Once these questions are answered, Clark suggests creating multiple conversions at that amount knowing that the IRS will allow you to keep the best performer and send the others back using something called recharacterization. A recharacterization allows you to “undo” or “reverse” a rollover or conversion to a Roth IRA. Read IRA FAQs - Recharacterization of Roth Rollovers and Conversions.

“So if you could convert $20,000, we would consider several at that amount with vastly different investments held in each account,” says Clark, who notes that the IRS will let you “cherry pick the best performer out of multiple conversions but not out of a single account.”

Your job then, if you’re acting as your own fiduciary, is to focus on risk and volatility, fees and expenses, taxes both today and tomorrow and making sure you are working toward a real return, says Clark.  “The Roth conversion strategy allows us to keep risk the same, not change the fees and put the burden of taxation on the back of the IRS,” he says. “I like that trade. If none of the Roth conversions go up enough to warrant keeping them, the IRS lets you send them all back. What a sweetheart deal.”

One other thing to consider: A Roth is always better for your beneficiary regardless of their tax bracket because you paid the taxes.

All that said, Clark recommends — knowing your current cash flow is tight — thinking twice before doing the conversion right now. “Assuming your health is in reasonable shape I would also delay taking the money from Social Security to allow for the compounding of future payments,” he says.

His advice: Because you are older, start with using your IRA funds first as you will be the first forced into required minimum distributions. You can then switch to using your husband’s IRA later as your IRA depletes. “The key here is to have as much income as possible in the lowest tax bracket,” he says.

As for the reverse mortgage, some experts suggest applying for a reverse mortgage with a line of credit as soon as possible. According to the Consumer Financial Protection Bureau:

• The line of credit option allows you to draw on your loan at the times and amounts that you choose (subject to the first-year cap and the overall initial principal limit). You will only be charged interest on the amount of money you take out. You will not be charged interest on the money remaining in your credit line, which you can take out at a later date.

Why might you do this? Having a reverse mortgage with line of credit in place gives you the option of taking money out of your house instead of your IRAs when markets are down.

According to a new study by Wade Pfau of the American College of Financial Services, strategic use of a reverse mortgage can improve retirement outcomes. “The benefits are non-linear in nature, as they relate to the synergies created by reducing sequence risk for portfolio withdrawals and to the non-recourse aspects of reverse mortgages that can potentially allow a (person) to spend more than the value of their home,” Pfau wrote in his study

In his study, Pfau explored six different methods for incorporating home equity into a retirement income plan through the use of a reverse mortgage. Now which method is best for you might require a discussion with a qualified and competent financial adviser.

But what Pfau’s study did conclude without equivocation was this: “A key theme is that there is great value for (people) to open a reverse mortgage line of credit at the earliest possible age,” he says.

Robert Powell is editor of Retirement Weekly, contributes regularly to USA TODAY, The Wall Street Journal and MarketWatch. Got questions about money? Emailrpowell@allthingsretirement.com.