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How to Reduce Your Tax Liability on a Roth IRA Conversion


Converting your current retirement accounts to a Roth IRA is typically a very tax-efficient strategy. It can help lower your lifetime taxes significantly. However, it does come with a large up-front bill.

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

If you need help executing a strategy to minimize your taxes, speak to a financial advisor today.

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Converting to a Roth IRA Triggers 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 may enjoy a tax break on your contributions going into these plans, you’ll face full income taxes when you eventually make withdrawals. You effectively pay no income taxes on the money you put in but full income taxes on the money you take out.

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

Since 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 into a Roth IRA to take advantage of the long-term tax savings.

There’s a catch though. When you move money from an IRA into a Roth IRA, for instance, you must essentially make up for the initial deduction you took 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 took it. This can increase your taxes, sometimes by quite a lot depending on the size of your transfer. 

You cannot avoid paying taxes on this money, however 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’re near retirement age, it’s important to note that you cannot make penalty-free withdrawals from a Roth IRA for five years after you open the account. So, take that into consideration when deciding on a conversion strategy.

Stagger Conversions 

It may make sense to avoid converting everything all at once. Instead, you can convert a little bit at a time. By making the conversion in pieces, you may be able to keep your tax bracket lower over a series of years, rather than if you converted everything up front.

The corollary to staggered conversion is tax bracket management. When you convert your IRA or 401(k) to a Roth IRA, you will add the value of this conversion to your taxable income for the year. If you’re not careful, this can raise your AGI enough to push you into a new tax bracket. While this won’t affect your taxes on income below the cutoff, you’ll pay even more in taxes on any conversion money above the new bracket. 

It can be very useful to keep an eye on how a conversion will affect your taxes. Convert enough to maximize your current bracket, but not enough to push you into a higher one. 

It may also be helpful to consider that the longer you take to convert your IRA, the more time your portfolio will have to grow and the more you may ultimately have to move (and pay taxes on). You also could miss out on tax-free growth in the Roth during this time. Speak to a financial advisor to explore ways to maximize your retirement income and minimize taxes.

Offset Capital Gains Losses

When you take investment losses, you can offset investment gains down to $0. After that, you can use investment losses to offset up to $3,000 in taxable income per year, indefinitely, as well.

This can be an excellent opportunity to do 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 that you will see from the IRA. 

Time Conversions to Market Downturns

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’re better off moving the smallest amount of money possible. This makes market downturns an opportunity to minimize your tax liability.

Time your conversion to when your IRA portfolio loses value. A 10% market downturn means that you might move 10% less cash over to your Roth IRA, reducing the impact on your taxes. However, you’ll also be contributing less to the Roth than if the market was 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 linked to your annual income. From student aid to Medicaid, tax credits and more, a vast number of different public and private entities base your eligibility on this or last year’s taxable income. 

For the self-employed, this is particularly essential. Your real, estimated and self-employment taxes are all based on your AGI, so a change in your taxed income can change several different areas of taxation.   Make sure to look at any program or grant that you depend on before making a conversion, and structure your conversion to keep your income below any applicable caps. You don’t want to roll your portfolio over just to discover that doing so made you ineligible for tuition assistance.

Bottom Line

A Roth IRA conversion is a very good long-term plan for most households, but it comes with a large tax bill attached. You cannot avoid paying those taxes, but you can structure your conversion to minimize its impact. A financial advisor can help with the entire process and help set you up for success while protecting your assets and maximizing your tax planning.

Roth IRA Planning Tips

  • Tax advantages are all well and good, but a Roth IRA is really only valuable if it delivers growth. Otherwise, you’re saving taxes on money that never actually happened. So… what kind of return can you expect from a Roth IRA? 
  • A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

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