Increasing IRA Conversion Benefits

A stream of tax-free income interests many people, and they know that a Roth IRA is a good way to establish tax-free cash flow. But they don’t want to pay taxes before they have to and balk at the tax cost of a conversion.

To convert a traditional IRA to a Roth IRA you include the converted amount in gross income as though it were distributed to you. You can reduce the taxes from the conversion and thereby increase the conversion’s benefits. In fact, when the opportunity to use one or more of these strategies arises, an IRA conversion that didn’t make sense in the past might make sense. Look for opportunities to use these strategies.

? Reduce gross income. A range of strategies can reduce gross income. You may have enough flexibility to reduce some income received for the year. Reduce optional distributions from IRAs and annuities. Defer salary from employment. Avoid taking capital gains by limiting asset sales during the year of the conversion. Take capital losses to offset gains.

Business losses from an S corporation, partnership, LLC, or a proprietorship reduce gross income. There are a number of hurdles in the tax code to taking the deductions. For example, you must materially participate in the activity, and it must be profit-seeking and not a hobby. But if you qualify and can time business income and expenses to generate a loss, it will reduce the cost of the IRA conversion.

? Reduce adjusted gross income. Gross income minus certain deductions leads to adjusted gross income (AGI). The deductions, listed on Form 1040, include retirement plan contributions, self-employeds’ health premiums, and one half of self-employment taxes.

? Increase charitable contributions. This is a strategy for people who are inclined to make significant charitable contributions either annually or through their estates. Bunching the contributions to years when an IRA is converted can make a lot of sense.

You don’t have to actually give all the money to charity the year of the conversion. You can donate to a donor-advised fund, such as those run by Schwab, Fidelity, and many localities. See our November 2014 visit for details.

? Donate appreciated assets. You can generate substantial charitable deductions without raising cash by donating appreciated assets. When appreciated securities and real estate are donated, you deduct the fair market value on the date of the contribution. You don’t owe capital gains taxes accrued during your ownership. This is a way to accelerate charitable contributions without tapping cash or incurring capital gains. Go through your portfolio and consider donating mutual funds, stocks, or real estate that are substantially higher than your purchase price.

? Take capital losses. Capital losses offset capital gains for the year dollar for dollar. Additional losses up to $3,000 can be deducted against other income. Any left over losses can be carried forward to future years and used in the same way.

When you sell assets that have paper losses or have carryovers of losses from past years, they make it possible to sell appreciated assets and shelter all or most of the capital gains. That generates more cash to pay the taxes for the Roth conversion. You’ve raised the cash to pay the taxes on the IRA conversion without incurring additional taxes. Or you can consider donating to charity the cash from selling losing assets so the deduction will offset some of your IRA conversion taxes. Run the numbers both ways to see which has the best cash flow.

The year you convert a traditional IRA or employer plan to a Roth IRA is likely to be the year with the highest taxable income of your life. Once you determine a conversion is a good idea, look for ways to reduce the tax cost and make it an even better idea.

RW April 2015.