Just about anyone who understands the benefits of a Roth IRA, will want to convert their traditional IRA money to a Roth IRA if they can, but the income tax consequences of the conversion can be significant. Thankfully, there are a couple of ways to work the conversion that will prevent you from losing money from a Roth IRA conversion. Not all of them are available to everyone, but all options are worth some investigation.
The Benefits of a Roth IRA Conversion
The benefits of converting a Traditional IRA to a Roth IRA are numerous, so here’s a quick refresher:
- Your distributions in retirement will be completely free of income tax
- The tax-free distributions will lower your overall income, protecting more of your Social Security benefits from taxation too
- You will completely eliminate the possibility of facing higher taxes in retirement than you are paying now (which will be entirely possible if you will have multiple retirement income streams)
- Roth IRA’s are almost unique among tax-sheltered retirement plans in that they don’t require RMDs (required minimum distributions), that are required on other qualified plans; that means you can preserve more of your retirement capital for your later years, allowing them to grow even larger
The Cost of Doing a Roth IRA Conversion
The downside of doing a Roth IRA conversion is that the amount of your IRA funds that are transferred to a Roth IRA will become taxable in the year of conversion. That will include all investment income earned on the traditional IRA, plus plan contributions on which you received a tax deduction in the year taken.
The only portion of the converted balance that won’t be subject to income taxes are any contributions to the traditional IRA that were not tax-deductible when made. However, you don’t get to pick and choose which amounts you transfer either (i.e., declaring that the amount converted was comprised entirely of non-deductible IRA contributions).
The IRS requires that you apportion any amount converted. You have to take the amount of your non-deductible IRA contributions, and divide it by the total amount of all of your IRA accounts.
For example; if you made $20,000 in non-deductible IRA contributions to your plan, but you have $200,000 in IRA account balances from all IRAs, then only 10% ($20,000 divided by $200,000) of any amount converted to a Roth IRA will escape income taxes in the year of conversion.
So how do you not lose money on an IRA conversion? There are a couple of ways.
Converting Non-Deductible IRA Funds
The easiest way to escape paying taxes on an IRA conversion is to make traditional IRA contributions when your income exceeds the threshold for deducting IRA contributions, then converting them to a Roth IRA.
If you’re covered by an employer retirement plan, the IRS limits IRA deductibility. For 2014, if you’re single, an IRA contribution is no longer deductible when your income reaches $70,000. If you’re married filing jointly, the limit is $116,000.
In order to be able to contribute directly to a Roth IRA, your income can’t exceed $129,000 for singles, and $191,000 for married filing jointly. However, there’s no income limit on Roth IRA conversions.
If you’re married and you make more than $116,000 (the IRA deductibility limit) you can make a contribution to your traditional IRA, then roll it over to a Roth IRA. If you do this immediately — as in before the traditional IRA has a chance to accumulate investment income — the rollover will take place without any income tax consequences, as long as you have no other traditional IRA balances.
What if you do have existing IRA balances? You can try to make them go away…
Leveraging Your 401(k) Plan
Some employer 401(k) plans will allow you to roll your traditional IRA accounts over into the plan. If they do, you can convert your existing IRA accounts to your 401(k). In doing so, you will no longer have IRA money, and you will no longer be required to apportion your Roth rollovers based on a percentage of your non-deductible IRA contributions. All new, non-tax deductible traditional IRA contributions can then be converted into Roth IRAs without tax consequences.
But what if your employer 401(k) doesn’t permit IRA rollovers?
If Your 401(k) Doesn’t Permit IRA Rollovers
The insurance industry has rolled out new products in recent years in order to make their annuities more competitive with other investment vehicles. One that is particularly interesting in connection with IRA conversions is the bonus annuity. These are annuities that pay you an upfront bonus of between 2% and 10% of the amount of the annuity.
Much like IRAs, annuities have the advantage of being tax deferred. A bonus annuity can offset the taxes paid on a partial IRA conversion.
For example; let’s say you have $200,000 in your IRA, and you want to roll part of it into a Roth IRA. If you move the entire balance of the plan into a bonus annuity IRA that pays a 7% bonus on the balance, that will be $14,000 in “found money”, that can be used to offset the taxes on the portion that will be converted to a Roth IRA.
If you are in the 28% tax bracket, you will be able to convert $50,000 of your IRA into a Roth without losing money. The rollover will result in a $14,000 tax liability ($50,000 X 0.28), but that will be offset by the 7% bonus that you will be paid on the $200,000 rollover to the annuity — which will be $14,000 ($200,000 X 0.07). You still have to pay the tax on the partial conversion, but that is covered by the bonus you receive on the total rollover.
Annuities aren’t the best investment choice for everyone. They do come with certain restrictions, and are usually packed with fees. In fact, the primary purpose of a bonus annuity is to cover surrender charges in the event that you decide to terminate your annuity before the contract allows you to do so without penalties.
How to Not Lose Money on a Roth IRA Conversion
If you want to do a Roth IRA conversion without losing money to income taxes, you should first try to do it by rolling your existing IRA accounts into your employer 401(k) plan, then converting non-deductible IRA contributions going forward.
The bonus annuity route should only be considered if the 401(k) option isn’t available to you. In either case, be sure to first consult your tax advisor, since the penalties for making a mistake on a Roth IRA conversion can be steep.
Readers: What conversion methods have you tried when attempting to avoid losing money on a Roth IRA conversion?