How to Reduce the Taxes on an IRA Conversion

One factor that keeps many people from converting all or part of a traditional IRA or 401(k) to a Roth IRA is the cost. A few simple strategies, and staying alert for opportunities, can dramatically reduce the cost of converting an IRA. Income taxes are the cost of converting an IRA.

The amount converted is included in gross income as though it were distributed to you, and you pay in- come taxes on it. You’re paying the taxes now instead of later, perhaps years later, when you take retirement distributions. You can reduce the cost of the con- version. Sometimes these actions make a conversion viable when it otherwise wouldn’t be.

Other times, they reduce the cost of a conversion you were going to do anyway, increasing lifetime tax- free income. The serial or multi-stage conversion. The tax code allows you to convert as much or as little of a traditional IRA as you want. If you convert an entire IRA at once, including that amount in gross income is likely to push you into a higher tax bracket and increase the tax bill.

That could cause you to pay more taxes than you would have by taking taxable distributions over the years. Paying taxes at a higher rate when you do the conversion than you would have in the future can eliminate the benefits of doing the conversion.

A better strategy is to convert only enough to ensure you stay in the same tax bracket. Estimate your taxable income for the year based on how your income and expenses stand now. Then, convert enough to keep your taxable income from rising to the next tax bracket. Using this strategy, you can convert the desired amount over several years while minimizing the tax cost.

But you need to monitor more than the income tax brackets. Determine if a conversion might trigger or increase the Stealth Taxes, such as the amount of Social Security benefits included in gross income, the Medicare premium surtax, and more. These taxes are discussed more in this month’s Tax Watch article. Also consider future Stealth Taxes when contemplating a conversion.

A conversion now could reduce future Stealth Taxes by converting ordinary in- come into tax-free income. That could make a conversion more attractive than it seems at first. You need to be aware of these Stealth Taxes, not only your income tax bracket, and include the estimated Stealth Taxes in the estimate of the tax costs and benefits of the conversion.

Lower gross income. Sometimes gross income can be reduced deliberately. Other times, circumstances reduce gross income, and you can take advantage by realizing it reduces the cost of converting part of a traditional IRA to a Roth IRA. A conversion would be less expensive if the lower gross income puts you in a lower tax bracket.

Or, if you’re still in the same tax bracket with the lower gross income, you’d be able to convert more of the traditional IRA at the same tax rate than you would have before. To avoid increasing gross income, you can delay selling investments at capital gains until next year.

Or when you need additional cash, avoid taking additional taxable distributions from a traditional IRA or a tax-deferred annuity. Take it from a tax-free source, if you can, such as a health savings account or Roth IRA. Look for other cash sources, such as investments that can be sold at little or no capital gain.

Short-term loans, such as a home equity line of credit or mar- gin loan against investments, also can be helpful. You can pay the loans the following tax year with an IRA distribution or other action.

Or, perhaps you can delay the expenditure or its payment until next year. When you’re still working, consider ways to defer income and bonuses to the following year. You also might be able to reduce gross income by increasing certain deductions. Possibilities include selling sell assets with capital losses or generating 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. Reduce adjusted gross income (AGI). AGI is on the first page of Form 1040 on line 11. The deductions you can take from gross income to arrive at AGI are on Schedule 1 of Form 1040.

All the deductions are too numerous to list here, but they include retirement plan contributions for the self-employed, health savings account contributions, medical insurance premiums for the self-employed, and one-half of self-employment taxes.

Review the form to see if you can take or increase any of the deductions. Increase charitable contributions. When you’re charitably inclined, increasing contributions for the year can reduce taxable income (when you itemize expenses) and reduce the cost of doing an IRA conversion. You can bunch several years of charitable contributions in one year by taking the money from savings. Contributing to a donor-advised fund is a popular way to do this.

Or you can donate an appreciated investment, such as shares of a stock or mutual fund. This doesn’t require any cash and allows you to deduct the fair market value of the shares without having to pay capital gains taxes on the appreciation that occurred while you owned the property. Pay the conversion taxes from non- IRA funds.

When you take cash out of the IRA to pay taxes on the conversion, 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 costs less when the con- version taxes are paid using cash from other accounts on which you already paid taxes. That also ensures the entire amount taken from the traditional IRA is rolled to the Roth IRA.

You receive a bigger payoff from the conversion by having more tax-free income in the future. Continue to monitor and evaluate your situation. You might determine early in the year that a conversion doesn’t make sense. But circumstances can change during the year.

Some people retire or are laid off during the year, causing a substantial drop in gross income. That might be a good opportunity to convert IRA assets or increase the amount you were planning to convert. Or deductions might increase.

Perhaps you incurred a large amount of deductible medical expenses. Or you decide to make a large charitable contribution that wasn’t planned earlier in the year. Changes in investment prices also can be a good time to review your decision. Suppose you planned to do a conversion at some point during the year.

The markets, or one of your investments, suddenly enters a correction or bear market. Convert the assets before the price recovers and you’ll turn more future ordinary income into tax-free income at the same tax cost. Or suppose you weren’t planning to do a conversion this year.

A significant market drop could improve the benefits of doing a conversion, because you’ll be able to convert more assets at the same tax cost. When you expect the prices to recover at some point, this is an opportunity to turn ordinary income into tax-free income at a reduced cost.

You don’t have to convert the same assets. You can sell the assets in the traditional IRA and convert the cash. After the cash is in the Roth IRA, it can be invested in other assets you believe are more likely to appreciate than the investment you sold.