Last month, we addressed the different factors to consider when evaluating whether it makes sense to convert a traditional IRA to a Roth IRA. While a Roth IRA has many benefits, there is a cost to the conversion. You have to include the converted amount in gross income as though it were distributed to you and pay income taxes on it.
Yet, there are steps you can take to reduce the tax cost of converting an IRA. These steps can make a conversion viable when it otherwise wouldn’t be, or they simply can reduce the cost of a conversion you were going to do, increasing your lifetime tax-free income.
Convert in stages. This is the easiest way to reduce the cost of an IRA conversion. An IRA conversion isn’t an allor-nothing decision. You can convert as much or as little of an IRA as you want, unless your IRA custodian establishes a minimum amount. Converting an entire IRA is likely to push you into a higher tax bracket, increasing the cost of the conversion.
A good strategy is to decide to convert an IRA in stages over several years. Convert only enough of the IRA each year to take you to the top of your current tax bracket. Also, be sure that you don’t convert so much that the higher income triggers some of the stealth taxes, such as the Medicare premium surtax, taxes on Social Security benefits, reduction or personal exemptions and itemized expenses, and more. See our April 2013 issue for details on the stealth taxes.
Convert assets to separate IRAs. In most conversions, a lump sum is moved from a traditional IRA to a Roth IRA. That’s okay, but a better method is to move each separate type of asset from the traditional IRA into its own Roth IRA. For example, put U.S. stock mutual funds in one Roth IRA, emerging market stocks in another Roth IRA, bonds in a third IRA and so forth. Some people even try to put each separate mutual fund or other asset in its own Roth IRA.
You might want to separate assets like this, because you are allowed to reverse an IRA conversion. Remember, when a conversion is done, you include in gross income the amount that was converted as of the day of the conversion. If the value of the Roth IRA declines after the conversion because of adverse market moves, you still pay taxes on the value on the day of the conversion. A significant decline in value of the Roth IRA is the main reason why you might want to reverse a conversion, an action known as a “recharacterization.” Reverse the conversion so you aren’t paying taxes on value that no longer exists, and consider trying another conversion in the future after the waiting period.
Converting the different assets into different Roth IRAs increases your recharacterization opportunities. If you move a diversified portfolio from a traditional IRA to a Roth IRA, it’s likely that parts of the portfolio will decline and parts will rise after the conversion. Except in a really bad market period, the net effect won’t be a significant enough loss to recharacterize the IRA. But if each asset is in a separate Roth IRA, then you can recharacterize any that had significant declines but allow the other assets to remain in their Roth IRAs. You can consolidate the separate Roth IRAs into one Roth IRA after the deadline for recharacterization has passed.
Reduce gross income. A conversion is less expensive if you are in a lower tax bracket. Or you can convert more of an IRA without triggering higher taxes if your income is lower. So, look for opportunities to reduce gross income, thereby increasing conversion opportunities. Avoiding or delaying action is one way to reduce gross income. For example, you can avoid selling investments at capital gains or taking IRA or annuity distributions that aren’t required. If you were considering these actions late in the year, see if you can defer them until January. When you’re still working, consider ways to defer income and bonuses to the following year.
Other ways to reduce gross income are to sell assets with capital losses or to generate business losses from S corporations, partnerships, or proprietorships. The tax rules for doing this can be tricky. But you might work with a tax advisor to determine if there are opportunities to manage income and expenses so there is a loss or less income for the year.
Reduce adjusted gross income (AGI). AGI is the last line on the first page of Form 1040. Certain deductions can be taken to reduce gross income and arrive at AGI. Deductions include retirement plan contributions, medical insurance premiums for the self-employed and one-half of self-employment taxes. Study the lists on the front of Form 1040 and in free IRS Publication 17, Your Federal Income Tax, to determine if there are any you can take.
Increase charitable contributions. When you’re charitably inclined, bunching contributions in one year can reduce the cost of doing an IRA conversion that year. You might be able to accelerate some contributions by taking money from savings, donating appreciated investments, or other strategies. Be sure to plan carefully so that the higher contributions aren’t reduced or offset by the limit on itemized deductions, alternative minimum tax, or other special tax code features.
Donating appreciated assets allows you to increase contributions without using cash. When donating stocks or mutual funds that have appreciated, you deduct the fair market value of the asset on the date of the contribution. There are no taxes due on the appreciation that occurred while you owned the property.
Pay the conversion taxes from other accounts. We discussed this last month, but it bears repeating. If you take cash out of the IRA to pay the taxes on the conversion, then you also include that amount in gross income and pay taxes on it. So, you’re sort of paying taxes on the taxes. A conversion is more viable when the conversion taxes are paid using cash from other accounts on which you already paid taxes. That way, the entire amount taken from the traditional IRA is rolled to the Roth IRA and generates more tax-free income in the future.
Continue to monitor and evaluate your situation. As we discussed earlier, you might want to recharacterize the IRA if it declines significantly in value. You also might want to recharacterize if your situation changes. You might be in a higher income tax bracket than expected or won’t have the cash to pay the conversion taxes. You also might want to recharacterize if a job loss or other change indicates you’ll be in a lower tax bracket the following year and can do a conversion then at a lower cost. Since the presidential election, there’s renewed potential for tax reform that will reduce income tax rates in a year or two.
You can recharacterize any time until your income tax return is due for the year of the conversion, including extensions. That means if you did a conversion in 2016, you have until October 15, 2017, to recharacterize. You don’t have to file an extension for your tax return in order to use the Oct. 15 date to recharacterize. So, keep following both the Roth IRA and your personal situation after the conversion in case reversing the conversion would be a good idea.