Investor Ed | Three ways to offset income from a Roth conversion (2024)

FAQs

Investor Ed | Three ways to offset income from a Roth conversion? ›

There is no way to avoid paying taxes on a Roth conversion. However, you can lower your tax burden by timing the conversion right.

There is no way to avoid paying taxes on a Roth conversion. However, you can lower your tax burden by timing the conversion right.

Although opening a "backdoor" Roth IRA may sound shady, don't let the name mislead you. It's a totally legal loophole. At its core, a backdoor Roth IRA is a simple conversion: You put money into a traditional IRA or 401(k), then convert it to a Roth IRA.

Bottom line. If you want to do a Roth IRA conversion without losing money to income taxes, you should first try to do it by rolling your existing IRA accounts into your employer 401(k) plan, then converting non-deductible IRA contributions going forward.

If deductible, the Roth conversion is taxable, offsetting the deduction. If nondeductible the Roth conversion is nontaxable. Only if the IRA contribution is made for some year before the year in which the Roth conversion tax place will there be any difference if you make the contribution deductible.

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.

Since a Roth conversion increases taxable income in the conversion year, drawbacks can include a higher tax bracket, more taxes on Social Security benefits, higher Medicare premiums, and lower college financial aid.

The Roth IRA five-year rule

The five-year rule could foil your withdrawal plans if you don't know about it ahead of time. This rule for Roth IRA distributions stipulates that five years must pass after the tax year of your first Roth IRA contribution before you can withdraw the earnings from the account tax-free.

Yes. Backdoor Roth IRAs are still allowed in 2024. However, there has been talk of eliminating the backdoor Roth in recent years. And the future is, of course, difficult to predict.

What is the best Roth conversion strategy? ›

In some cases, a Roth IRA can provide you with so much reportable income that you're bumped into a higher tax bracket. With a bracket-bumping conversion strategy, you can avoid this scenario by converting only a portion of your funds to preserve your current tax bracket.

However, there are no limits on conversions. A taxpayer with a pre-tax IRA can convert any amount of funds in a year to a Roth IRA. Roth IRAs also are exempt from required minimum distributions (RMDs). These mandatory withdrawals from retirement accounts begin at age 72 and can create a tax burden on affluent retirees.

The Five-Year Rule

The best time to convert from a traditional to a Roth IRA is generally when the market is down and your traditional IRA has lost value, and/or your income is unusually low, and/or your itemized deductions for the year have increased.

You're never too old to fund a Roth IRA. Opening a later-in-life Roth IRA means you don't have to worry about the early withdrawal penalty on earnings if you're 59½. No matter when you open a Roth IRA, you have to wait five years to withdraw the earnings tax-free.

If you convert a substantial traditional IRA to a Roth IRA early in the year, then your quarterly income—and therefore, your quarterly taxes—will increase. Say you convert during the first quarter of the year. You would need to pay the tax triggered by the conversion when your quarterlies are due.

The amount you choose to convert (you don't have to convert the entire account) will be taxed as ordinary income in the year you convert. So you'll need to have enough cash saved to pay the taxes on the amount you convert.

You'd owe income tax on the entire amount that you convert from a traditional IRA into a Roth IRA in the year you make the switch. The amount of tax will depend on your income tax bracket and income tax rate—between 10% and 37% as of 2024. 1 The money you convert is added to your gross income for the tax year.

This is because a five-year waiting period is required if you are under age 59 1/2 before you can distribute the converted amount without owing the 10% additional tax. The longer the assets in the Roth IRA can be left untouched, the greater the benefit of tax-free earnings potentially accumulating.

People over age 59½ who've held their accounts for at least five years can withdraw contributions and earnings with no tax or penalty. Special exceptions apply for those who are under 59½ or who don't meet the five-year rule if they make withdrawals for a first-time home purchase, college expenses, or other situations.