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Converting a large sum like $865,000 to a Roth IRA is a strategic move for long-term tax benefits – including tax-free retirement income and eliminating required minimum distributions (RMDs) – but it often comes with a hefty upfront tax bill. The transition from a traditional IRA or 401(k) to a Roth IRA means paying taxes on the converted funds. But, with careful planning and strategic execution, it’s possible to minimize the tax impact. Here’s how you can do it.
Get matched with a financial advisor who can help you convert your retirement funds.
Understand the Basics of Roth IRA Conversions
When you convert funds from a traditional IRA or 401(k) to a Roth IRA, you’re essentially converting pre-tax dollars to after-tax dollars. This conversion triggers a taxable event, meaning you’ll owe income tax on the amount converted. The key to minimizing taxes lies in understanding the timing and amount.
Strategy 1: Partial Conversions Over Several Years
Instead of moving the entire $865,000 in one year, consider spreading it across multiple years. This strategy helps to avoid pushing yourself into a higher tax bracket. For example, if you’re currently in the 24% tax bracket, converting a large sum might push you into the 32% or 35% tax bracket, significantly increasing your tax liability.
Example Strategy:
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Year 1: Convert $200,000
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Year 2: Convert $200,000
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Year 3: Convert $200,000
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Year 4: Convert $200,000
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Year 5: Convert $65,000
By spreading out the conversion, you keep your taxable income lower each year, potentially saving thousands in taxes.
Keep in mind, any amount you convert will typically be subject to the five-year rule, which means you can’t withdraw the converted amount without penalty for five years after you convert it.
A financial advisor can help you devise a personalized conversion strategy to minimize your conversion taxes. Talk to an advisor today.
Strategy 2: Leverage Lower Income Years
If you anticipate a year with lower income — such as retirement or a sabbatical — that might be the ideal time to execute a conversion (though you may have to wait five years to use that income). During a lower income year, your overall taxable income will be less, which means the rollover amount will be taxed at a lower rate.
Example Scenario: If you retire at 62 and plan to start taking Social Security at 67, the years between 62 and 67 might be prime for Roth conversions. With no employment income and delayed Social Security, your taxable income is lower, allowing for a more tax-efficient rollover.
Strategy 3: Utilize Tax Deductions and Credits
Take advantage of available tax deductions and credits to offset the tax liability of your rollover. Charitable contributions, medical expenses and business losses are examples of deductions that can lower your taxable income.
Example Tactics:
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Charitable Contributions: If you itemize deductions, making large charitable contributions in the same year as your rollover can offset the increased taxable income.
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Medical Expenses: If you have significant medical expenses that exceed 7.5% of your adjusted gross income, these can also be deducted, reducing your taxable income.
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Business Losses: If you own a business, operational losses may be able to be used to offset your taxable income from the rollover.
Strategy 4: Contribute to a Health Savings Account (HSA)
Contributing to an HSA can lower your taxable income. HSAs offer triple tax benefits: contributions are tax-deductible, growth is tax-free, and withdrawals for qualified medical expenses are tax-free. Maximize your HSA contributions to reduce your overall taxable income.
Strategy 5: Convert During Market Downturns
When the market is down, the value of your traditional IRA or 401(k) investments may be lower. Converting during a downturn means you’re rolling over a smaller amount, thus incurring a lower tax bill. Additionally, any subsequent growth happens tax-free within the Roth IRA.
Consulting with a Financial Advisor
Given the complexity of tax laws and the significant amount involved, consulting with a financial advisor or tax professional is crucial. They can help tailor a strategy specific to your financial situation and goals, ensuring you maximize the benefits while minimizing the tax burden. If you are searching for a fiduciary financial advisor, this free tool can match you with up to three.
The Bottom Line
Rolling over $865,000 to a Roth IRA is a savvy financial move for long-term tax benefits, but it requires careful planning to avoid a large tax bill. By spreading the conversion over multiple years, leveraging lower income years, utilizing tax deductions and credits, contributing to an HSA and converting during market downturns, you can strategically minimize your tax liability. Consult with a financial advisor to develop a personalized plan that aligns with your financial goals.
Tools for Retirement Planning
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How much money will you need to retire? Find out by using the SmartAsset retirement calculator.
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Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
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Are you a financial advisor looking to grow your business? SmartAsset AMP helps advisors connect with leads and offers marketing automation solutions so you can spend more time making conversions. Learn more about SmartAsset AMP.
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