Q. How to minimize Roth IRA conversion's tax impact?
A. The benefits of a Roth IRA are clear: tax-free growth and tax-free withdrawals. But not everyone may be able to contribute to a Roth IRA because of IRS-imposed income restrictions on contributions. But anyone can convert existing money in a traditional IRA or other tax-deferred retirement savings account to a Roth IRA.
A Roth IRA conversion does have a cost - income taxes need to be paid on the converted amount. Taxes are "front-loaded," which allows the money in the Roth IRA to grow tax-free.
We will discuss 2 ways to help manage taxes.
Method 1. Spread the Cost
This method involves converting the Roth IRA over a few years. This spreads the taxes too, and it may also prevent the income from the conversion causing a bump into a higher tax bracket.
An example
Imagine a married couple who expect to file jointly with $100,000 in taxable income. They could convert up to $50,000 to a Roth IRA and stay within their current tax bracket, which applies to taxable income between $90,000 and $150,000. As long as their tax rate and income generally stay the same, they could convert this amount yearly until they reach the total amount they want to convert. The potential benefit is that they maintain a consistent tax rate when converting (provided their situation and the tax rates don’t change in the ensuing years.) If they converted more than $50,000, any amount over the current marginal rate income range would be taxed at the next higher marginal rate.
Two considerations
First, a conversion must be completed by December 31. Estimating taxable income can be tricky without all tax reporting documents, which aren't typically available until late January of the following year, at the earliest. So, your estimated taxable income may end up being higher or lower than expected.
Second, for those near the top of their bracket, it may take a long time to convert the total amount wanted without moving into a higher bracket. For example, for joint filers with $100,000 in taxable income, the next bracket begins at $150,000. Converting only $10,000 would keep the filers within the same bracket.
In our next blogpost, we will discuss method two to minimize tax when convert to Roth IRA.
A. The benefits of a Roth IRA are clear: tax-free growth and tax-free withdrawals. But not everyone may be able to contribute to a Roth IRA because of IRS-imposed income restrictions on contributions. But anyone can convert existing money in a traditional IRA or other tax-deferred retirement savings account to a Roth IRA.
A Roth IRA conversion does have a cost - income taxes need to be paid on the converted amount. Taxes are "front-loaded," which allows the money in the Roth IRA to grow tax-free.
We will discuss 2 ways to help manage taxes.
Method 1. Spread the Cost
This method involves converting the Roth IRA over a few years. This spreads the taxes too, and it may also prevent the income from the conversion causing a bump into a higher tax bracket.
An example
Imagine a married couple who expect to file jointly with $100,000 in taxable income. They could convert up to $50,000 to a Roth IRA and stay within their current tax bracket, which applies to taxable income between $90,000 and $150,000. As long as their tax rate and income generally stay the same, they could convert this amount yearly until they reach the total amount they want to convert. The potential benefit is that they maintain a consistent tax rate when converting (provided their situation and the tax rates don’t change in the ensuing years.) If they converted more than $50,000, any amount over the current marginal rate income range would be taxed at the next higher marginal rate.
Two considerations
First, a conversion must be completed by December 31. Estimating taxable income can be tricky without all tax reporting documents, which aren't typically available until late January of the following year, at the earliest. So, your estimated taxable income may end up being higher or lower than expected.
Second, for those near the top of their bracket, it may take a long time to convert the total amount wanted without moving into a higher bracket. For example, for joint filers with $100,000 in taxable income, the next bracket begins at $150,000. Converting only $10,000 would keep the filers within the same bracket.
In our next blogpost, we will discuss method two to minimize tax when convert to Roth IRA.
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