How to Reduce Your Tax Liability on a Roth IRA Conversion

By | March 29, 2024

Converting your current retirement accounts to a Roth IRA is generally a very tax-efficient strategy. It can help you significantly reduce your lifetime taxes. However, there is a large upfront bill.

While there’s no way to completely avoid conversion taxes, you can restructure them to make it much more manageable. By spreading out or timing your conversion during years when you have low tax liability or portfolio losses, you can reduce the impact of a Roth IRA conversion.

If you need help implementing a strategy to minimize your taxes, contact a financial advisor today.

Converting to a Roth IRA results in income taxes

Traditional qualifying employer-sponsored retirement accounts have opposite tax treatments compared to Roth IRAs.

Retirement accounts such as traditional IRAs, 401(k)s and 403(b)s are called “pre-tax accounts.” This means that while you will receive a tax benefit on your contributions participating in these plans, you will face full income tax liability when you ultimately withdraw funds. You actually pay no income tax on the money you put in, but full income tax on the money you take out.

On the other hand, Roth IRAs are called “post-tax” accounts. Although you can’t take a deduction for the money you contribute, you won’t have to pay income taxes on your withdrawals at all. Essentially, you pay full income tax on the money you put in, but no income tax on the money you take out.

Because your portfolio gains will almost certainly exceed your contributions given enough time and the right allocations, a Roth IRA is one of the best tax-advantaged retirement accounts for most households. This is why many people like to take advantage of Roth IRA conversions – moving their money from a traditional IRA to a Roth IRA to take advantage of the long-term tax savings.

However, there is a catch. For example, when you move money from an IRA to a Roth IRA, you essentially have to make up the initial deduction by paying income taxes on the full value of your conversion. In practice, this means that you add the value of a conversion to your taxable income for the year in which you included it. This can increase your taxes, sometimes by quite a bit, depending on the size of your transfer.

You can’t avoid paying taxes on this money, but you can reduce the impact of a conversion. Here are a few strategies to consider.

A financial advisor can help you weigh the pros and cons of a Roth conversion in your personal situation.

Strategies to Reduce Your Conversion Taxes

If you are approaching retirement age, it is important to note that you cannot make penalty-free withdrawals from a Roth IRA for five years after account opening. So keep that in mind when choosing a conversion strategy.

Spread conversions

It may make sense to avoid converting everything at once. Instead, you can convert bit by bit. By doing the conversion piecemeal, you may be able to keep your tax bracket lower over a number of years, rather than converting everything up front.

The consequence of staggered conversion is the management of tax brackets. When you convert your IRA or 401(k) to a Roth IRA, you add the value of this conversion to your taxable income for the year. If you’re not careful, this could increase your AGI enough to put you in a new tax bracket. While this won’t affect your taxes on income below the limit, you’ll pay even more taxes on conversion money above the new bracket.

It can be very useful to keep an eye on the consequences a conversion has for your taxes. Convert enough to maximize your current drive, but not enough to push you to a higher drive.

It can also be helpful to remember that the longer it takes you to convert your IRA, the more time your portfolio will have to grow and the more you will ultimately have to move (and pay taxes). You could also miss out on Roth tax-free growth during this time.

Talk to a financial advisor to explore ways to maximize your retirement income and minimize taxes.

Compensate for capital gains losses

When you recognize investment losses, you can offset investment gains up to $0. You can then use investment losses to offset up to €3,000 in taxable income per year indefinitely.

This can be an excellent opportunity to make a limited Roth IRA conversion. By writing down up to $3,000 in capital gains losses, you can offset some of the increased taxable income you’ll see from the IRA.

Time conversions to market declines

Similarly, you can also time your conversion to unrealized losses in the stock market.

When you make a Roth IRA conversion, you increase your taxable income by the entire amount converted. As a result, you are better off moving as small an amount as possible. This turns market declines into an opportunity to minimize your tax liability. Time your conversion until your IRA portfolio loses value. A 10% market decline means you may transfer 10% less money to your Roth IRA, reducing the impact on your taxes. However, you also contribute less to the Roth than if the market were in better shape.

A financial advisor can help you project your income and taxes in multiple scenarios.

Pay attention to income triggers

Finally, remember that the rules for many different programs are tied to your annual income. From student aid to Medicaid, tax credits and more, a wide variety of public and private entities base your eligibility on this or last year’s taxable income.

This is especially essential for the self-employed. Your actual, estimated, and self-employment taxes are all based on your AGI, so a change in your taxable income can change several tax areas.

Be sure to review any program or grant you depend on before converting, and structure your conversion so that your income remains below applicable limits. You don’t want to transfer your portfolio only to discover that it means you no longer qualify for tuition assistance.

In short

A Roth IRA conversion is a very good long-term plan for most households, but it does come with a large tax bill. You can’t avoid paying these taxes, but you can structure your conversion to minimize their impact.

Roth IRA Planning Tips

  • Tax benefits are all well and good, but a Roth IRA is really only valuable if it produces growth. Otherwise you will save taxes on money that never actually happened. So…what kind of returns can you expect from a Roth IRA?

  • A financial advisor can help you draw up a comprehensive retirement plan. Finding a financial advisor does not have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can have a free introductory meeting with your advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

Photo credits: ©iStock.com/Xesai, ©iStock.com/uchar, ©iStock.com/Anna Frank

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