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How to Reduce Your Tax Liability on a Roth IRA Conversion

How to Reduce Your Tax Liability on a Roth IRA Conversion


Converting your current retirement accounts into one Roth IRA is generally a very tax-efficient strategy. This can help you significantly reduce your lifetime taxes. However, this comes with a hefty upfront bill.

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

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

Roth IRA conversion triggers income taxes

Qualified employer-sponsored traditional retirement accounts receive opposite tax treatments from Roth IRAs.

Retirement accounts such as Traditional IRAs, 401(k)sAnd 403(b)s are called “pre-tax” accounts. This means that although you receive tax relief on your contributions to these plans, you will have to pay full income tax when you eventually make withdrawals. In fact, you pay no income tax on the money you invest, but full income tax on the money you withdraw.

On the other hand, Roth IRAs are called “after-tax” accounts. Although you can’t deduct the money you contribute, you don’t have to pay income tax on your withdrawals at all. This is because you pay full income tax on the money you invest, but no income tax on the money you withdraw.

Since your portfolio’s earnings 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 – transfer their money from a traditional IRA to a Roth IRA to take advantage of long-term tax savings.

There is, however, a catch. When you transfer money from an IRA to a Roth IRAFor example, you essentially have to offset the initial deduction you took by paying income taxes on the full value of your conversion. In practice, this means you add the value of a conversion to your taxable income in the year you made it. This can increase your taxes, sometimes significantly 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 some 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 Fees

If you’re close to retirement age, it’s important to note that you can’t make penalty-free withdrawals from a Roth IRA for five years after opening the account. So, take this into account when deciding on a conversion strategy.

Staggered Conversions

It may be wise to avoid converting everything at once. Instead, you can convert little by little. By converting to chunks, you may be able to keep your tax bracket decrease over a series of years, rather than if you converted everything up front.

The corollary of a staged conversion is the management of tax brackets. When you convert your IRA or 401(k) to a Roth IRA, you will add the value of that conversion to your taxable income for the year. If you are not careful, it can increase your AGI enough to push you into a new tax bracket. While this won’t affect your taxes on income below the threshold, you’ll pay even more tax on any conversion amounts above the new bracket.

It can be very helpful to keep an eye on the impact of a conversion on your taxes. Convert enough to max out your current bracket, but not enough to push yourself into a higher bracket.

It may also be worth considering that the longer you take to convert your IRA, the more time your portfolio will have to grow and the more you will eventually have to move (and pay taxes). You could also miss out on tax-free Roth 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 incur investment losses, you can offset investment gains up to $0. After that, you can also use investment losses to offset up to $3,000 of taxable income per year, indefinitely.

This can be a great opportunity to do a limited Roth IRA conversion. By writing up to $3,000 capital gains, lossesyou can offset some of the increase in taxable income you’ll see with the IRA.

Time Conversions to Market Downturns

Likewise, 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 converted amount. As a result, it’s best to move as little money as possible. This makes market downturns an opportunity to minimize your tax liability. Time your conversion for when your IRA portfolio loses value. A 10% market downturn means you could move 10% less money into your Roth IRA, reducing the impact on your taxes. However, you will also contribute less to the Roth than if the market were in better shape.

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

Pay attention to revenue 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 lot of different public and private entities base your eligibility on this year’s or last year’s taxable income.

For freelancers, this is particularly essential. Your actual, 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.

Be sure to review any programs or grants you rely on before converting, and structure your conversion to keep your income below applicable limits. You don’t want to roll over your portfolio just to find out that it makes you ineligible for tuition assistance.

Conclusion

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

Roth IRA planning tips

  • Tax benefits are all well and good, but a Roth IRA is only truly valuable if it generates growth. Otherwise, you’ll save taxes on money that was never realized. So…what kind of return can you expect from a Roth IRA?

  • A financial advisor can help you develop a comprehensive retirement plan. Finding a financial advisor doesn’t have to be difficult. The free SmartAsset tool connects you with up to three licensed financial advisors who serve your area, and you can have a free introductory call with your advisor to decide which one seems best for you. If you are ready to find an advisor who can help you achieve your financial goals, start now.

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

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