If I have a tax-deferred 401(k). Can I convert it to a Roth IRA without paying tax-deferred when I return it?
-Tommy
Generally, the answer is no. There is usually no way to completely avoid tax on a Roth conversion. Eventually, Uncle Sam will come to collect your tax-deferred retirement accounts—whether you make a Roth conversion, withdraw funds, or withdraw your required minimum distributions (RMDs).
However, your inability to completely avoid taxes doesn’t mean you can’t reduce them. Here are some smart strategies to lower your tax bill on a Roth conversion. (For more information on taxes and pensions, consider working with a financial advisor.)
Strategies for Lowering Your Tax Bill on a Roth Conversion
To minimize the tax consequences of switching from a tax-deferred account to a Roth, consider these methods:
Do a tax-sensitive partial Roth conversion
One a strategy to reduce the tax liability of a Roth conversion includes a gap between rollovers over several years. To use this strategy, convert just enough to bring your total income up to the limits of your current tax bracket without moving into the next bracket. (For more information on taxes and pensions, consider working with a financial advisor.)
Get your money back in a low tax year
For many people, a prime time for Roth conversions takes place during the years after retirement, but before Social security and RMDs begin. These may be relatively low-income years during which initiating a conversion can result in a triple benefit. Those benefits are: smaller tax bills, reduced RMDs, and tax-free future growth.
Speaking of timing, if you suspect that tax rates will increase in the expected sunset Law on Tax Reduction and Employment or due to political machinations on Capitol Hill, a Roth conversion may now be an option.
You’ll lock in your current tax rate and hopefully withstand any future increases. Keep in mind that no one has a crystal ball, and this strategy involves predicting the future. (For more information on how tax policy can affect retirement planning, consider working with a financial advisor.)
Pay your taxes wisely
Many experts recommend paying the taxes on your Roth conversion with non-retirement assets. This is the opposite of withholding part of your retirement funds to pay the bills. This will allow you to transfer the largest amount into your new Roth account and continue to watch it grow tax-free.
Work with a financial advisor
Financial advisor can help you take a holistic view of your tax and retirement profile, identifying opportunities to reduce taxes while adhering to an investment philosophy that suits your life stage.
