Benefits
How to Spread Out the Tax Bite on Roth Conversions
Unless you’ve been marooned on a desert island somewhere for the last few decades, you should know all about the benefits of Roth IRAs. But you may have built a sizeable nest egg in a traditional IRA, including a rollover from a 401(k) or other ...
Sep. 10, 2021
Unless you’ve been marooned on a desert island somewhere for the last few decades, you should know all about the benefits of Roth IRAs. But you may have built a sizeable nest egg in a traditional IRA, including a rollover from a 401(k) or other company plan. If you convert the traditional IRA to a Roth this year, you’ll have to pay a hefty tax price.
One possible alternative is to “divide and conquer.” Instead of converting all the funds in a single year, you might spread out the conversion over a series of years to reduce the overall tax bite.
First, let’s review the basic rules. If you receive “qualified distributions” from a Roth in existence for at least five years, the payouts are completely exempt from tax. Qualified distributions include those made after reaching age 59½, made on account of death or disability or used to pay first-time homebuyer expenses (up to a lifetime limit of $10,000). In contrast, distributions from a traditional IRA are taxable at ordinary income rates, now topping out at 37% (and they could go higher).
Also, you don’t have to take required minimum distributions (RMDs) from a Roth IRA during your lifetime. With a traditional IRA, you must begin taking RMDs after age 72 (recently increased from age 70½).
The trade-off is that you have to pay current tax at ordinary income rates on the amount you convert. For instance, if your traditional IRA is valued at $1 million and you convert the entire amount, you’ll owe a conversion tax of $370,000 if you’re already in the top 37% tax bracket in 2021.
Furthermore, you must contend with 3.8% “net investment income tax”(NIIT).
The NIIT applies to the lesser of the lesser of net investment income or the amount by which modified adjusted gross income (MAGI) exceeds $200,000 for single filers or $250,000 for joint filers. For this purpose, “net investment income” includes interest, dividends, royalties, rents, gains from dispositions of property (other than sales of an active trade or business) and income from passive activities, but not tax-free interest or distributions from qualified retirement plans and IRAs.
Although the amount converted to a Roth doesn’t count as net investment income, it could still raise your MAGI, thereby triggering additional tax in the year of a conversion.
Of course, there are several financial and personal factors to consider before you convert. It’s NOT for everyone. However, assuming a conversion still makes sense, you can minimize the tax damage with some forethought.
Practical approach: Figure out an amount to convert each year. The goal is to stay within the lower tax brackets within jumping into a higher tax bracket. For example, in 2021 the top 37% tax bracket for a joint filer begins at $628,301 of taxable income. Suppose you have $425,000 of income this year. If you convert $200,000 in a $1 million traditional IRA this year, the entire conversion is taxed at the 35% rate instead of any portion being taxed at the 37% rate. Follow the same path in succeeding years.
This principle also applies to folks in lower tax brackets. In fact, if you’re careful, you may also be able to avoid NIIT liability. Have your tax advisor crunch the numbers for you.