How to Reduce Your Tax Liability on a Roth IRA Conversion

Most of the time, switching from a traditional retirement account to a Roth IRA is the best way to save on taxes. It can help you pay a lot less in taxes over your lifetime. It does, however, come with a big bill up front.

There is no way to fully avoid conversion taxes, but you can change how they are worked out to make things a lot easier. A Roth IRA change can have less of an effect on your finances if you do it over time or in years when your tax bill is low or when your portfolio does not lose much value.

Making the switch to a Roth IRA Sets off income taxes

When it comes to taxes, traditional qualified employer-sponsored retirement accounts and Roth IRAs are not the same.

People who have standard IRAs, 401(k)s, and 403(b)s can put money into “pre-tax” accounts. In other words, you might get a tax break on the money you put into these plans, but you will have to pay full income taxes when you take money out. When you put money into an account, you do not have to pay income taxes on it, but when you take money out, you do.

One type of account, called a “post-tax” account, is a Roth IRA. It is not possible to recover the money you put in, but you do not have to pay taxes on the money you take out. To put it another way, you pay taxes on the money you put in but not on the money you take out.

With enough time and the right investments, a Roth IRA is one of the best tax-advantaged retirement accounts for most families. This is because your portfolio gains will almost certainly be higher than your payments. The long-term tax savings are one reason why a lot of people like Roth IRA conversions—moving their money from a regular IRA to a Roth IRA.

But there is a catch. For example, if you move money from an IRA to a Roth IRA, you have to pay income taxes on the full amount of your change to make up for the tax break you got at first. In real life, this means that the amount of a conversion is added to your taxable income for the year it was taken. If you make a large move, this could make your taxes go up, sometimes by a lot.

You can not keep this money from being taxed, but you can lessen the effect of a change. Here are some ideas for you to think about. A financial expert can help you think about the pros and cons of converting your Roth to a different type of account.

Different ways to lower your conversion taxes

Once you start a Roth IRA, you have five years to take money out without paying a fee. This is important to know if you are getting close to retirement age. That is something to think about when choosing a conversion plan.

Spread out conversions

It might not be necessary to change everything at once. You can change small amounts at a time instead. Instead of converting everything all at once, you might be able to keep your tax band lower over a number of years if you do it in pieces.

Tax bracket management goes hand in hand with staggered change. If you change your IRA or 401(k) to a Roth IRA, the value of the change will be added to your taxed income for the year. If you’re not careful, this can raise your AGI enough to push you into a new tax rate. 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 rate.

You might find it helpful to keep an eye on how an exchange will change your taxes. Change it just enough to get the most out of your present bracket, but not enough to move you up to a higher one.

You might also want to keep in mind that the longer you wait to change your IRA, the longer your portfolio will have to grow and the more you may have to move (and pay taxes on). During this time, you might also miss out on growth in the Roth that is not taxed. Talk to a financial expert about how to get the most out of your retirement income while paying the least amount of taxes.

Make up for lost capital gains

If you take out investment losses, you can wipe out investment wins until you have no money left. When you reach that point, you can always use financial losses to lower your taxable income by up to $3,000.

If you want to do a limited Roth IRA change, this could be a great chance. You can save some of the extra money you will have to pay in taxes because of the IRA by writing down up to $3,000 in capital gains losses.

Changes in time for market downturns

In the same way, you can time your stock market change to unrealized losses. When you convert a Roth IRA, the full amount you converted is added to your taxed income. Since this is the case, you should move as little money as possible. This means that when the market goes down, you can lower your tax bill.

Plan your conversion for when the value of your IRA stock goes down. If the market drops by 10%, you might move 10% less money into your Roth IRA, which will have less of an effect on your taxes. You will, however, put less money into the Roth than you would if the market were better.

A financial expert can help you figure out how much money you will make and how much tax you will have to pay in different situations.

Pay attention to what brings in money.

Finally, keep in mind that the rules for many programs depend on how much money you make each year. A huge range of public and private organizations, from student loans and Medicaid to tax credits and more, use your taxed income from this year or last year to decide if they will give you money.

This is especially important for people who are self-employed. All of your taxes—real, estimated, and self-employment—are based on your AGI. If your taxed income changes, it can affect more than one area of your taxes.

Before you make a conversion, make sure to check out any programs or grants you depend on. Also, make sure that the way you arrange your conversion keeps your income below any limiting rules. You do not want to roll over your stock only to find out that you can not get financial aid for school because of it.