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You know the deal with a traditional IRA. You put your tax-deferred money in and breathe a sigh that you didn’t pay taxes on that income. However, looming over your shoulder is the knowledge that eventually, you will pay big for the withdrawal of those funds. Is there anything you can do to minimize the impact?
Yes. The best thing to do is not to put off planning your IRA tax strategy and do something now to reduce your future tax burden. Instead, start paying something now. Why? You should do this because certain years are better than others for paying extra tax. You see, certain circumstances allow you to have additional taxable income but not actually pay any more in taxes. Here are some scenarios:
- You can offset your income with losses;
- You fall into a lower tax bracket than usual this year because of less income from other sources;
- The current year’s tax rates are lower overall; or
- Some of your investments lose value, such as in a downturn in the stock market.
You may think it would be hard to know when these scenarios will pop up. Fortunately, tax law itself gives you some assistance in making the most of these opportunities.
Switching between Traditional and Roth IRAs
As mentioned above, both your contributions and earnings are taxed when you withdraw cash from your IRA. Make those withdrawals when you’re in a high tax bracket, and you could be eating up your retirement savings pretty quickly. This is especially applicable if you choose to continue working after you reach retirement age. Your work income makes it more likely that you’ll be in a higher bracket. Additionally, once you reach 70 ½ you’re required to take mandatory distributions from your traditional IRA.
Unlike a traditional IRA, you pay taxes up-front with a Roth IRA. Because of this, you can convert from traditional to Roth in order to pay taxes at the most opportune time for you. Here’s the basic information you need:
- When you convert to the Roth IRA, you will pay taxes, so make the conversion in a year when you plan to have a lower tax bill.
- After converting, your earnings will continue to accrue and compound tax-free within the Roth IRA.
- You can undo the conversion (or just a part of the conversion) up until October 15 of the next year, allowing you to make a strategy for how much tax to pay in that year.
- Since you’ve already paid taxes upon conversion to the Roth IRA, you can withdraw money from it without paying any taxes again, as long as you’re at least 59 ½. This includes on the earnings you make. You will have to wait five years from your first Roth IRA contribution (for any Roth IRA in your name) to take advantage of this.[1]
So, let’s say you expect to claim a $20,000 loss on your federal income tax return this year. From your traditional IRA, you transfer $20,000 to a Roth IRA. What happens next? First, you get a tax deduction for the amount you put into the traditional IRA. Then, you pay no taxes on the transfer to a Roth IRA. Finally, once you’re 59 ½ you pay no taxes when you withdraw the money from the Roth account (again, as long as it’s been at least five years since your first ever Roth contribution).
Now, here’s the part that really reduces your risk from this strategy. You are allowed to undo the Roth conversion![2] For instance, you may have transferred funds from a traditional IRA to a Roth account because your business had been slow and you expected a low tax year (the perfect time to pay IRA taxes). However, after the conversion, it’s possible that your business takes off and your income increases.
In this case, the increased income could put you in a higher tax bracket and make it less beneficial to pay those taxes now. No problem. The IRS will allow you to undo the conversion. They also call this “recharacterizing” the conversion. Simply put, it’s like you never transferred funds to a Roth IRA in the first place. If you find yourself in this situation, just make sure you keep an eye on deadlines—you have until your next tax return is due to undo the change.
Hint: You can give yourself some time to decide whether you need to recharacterize the conversion by applying for a filing extension on your tax return. You’ll then have until October 15. Just as you can undo a conversion, you can also redo it when the time is right, but you’ll have to wait until the later of 1) 30 days after the initial recharacterization or 2) the start of the next year after conversion.[3]
Other Factors to Consider
There is another reason, aside from increased income, why you may want to undo an IRA conversion. You could experience a decline in value for your investments after you make the transfer. If you convert $50,000 from your traditional IRA to a Roth IRA, and the investments drop in value to $30,000, you’ll end up paying higher taxes than if you’d converted after the drop in value. You pay $16,500 for the larger transfer, whereas you would have only paid $9,900 for transferring the smaller amount.[4]
If your investment value drops, why would you want to be stuck with thousands of dollars more in taxes? Instead, you just recharacterize the conversion and save that extra $6,600, waiting to convert the $30,000 back to a Roth IRA once the wait period is up.
As if this strategy isn’t advantageous enough, there’s actually something else you can do to maximize your tax benefit. Do you have multiple investments in your traditional IRA? If so, it would be a smart move to convert those investments separately into their own Roth IRA.
Keeping in mind the example above about declining investments, consider the following scenario. You have a Roth IRA in which you converted two different investments. The value of one increases at the same time that the other’s value decreases. Now, you have to decide whether to undo the conversion, but both investments are tied together (i.e. you cannot undo only one). Don’t get yourself into that frustrating situation!
Instead, transfer each investment into its own separate Roth IRA. Now, when the investments perform differently, you can choose which conversion to recharacterize, giving you more control over your tax strategy.[5] Once the conversions are complete and taxes are paid, you can later consolidate the two accounts, making them easier to maintain.
Although it takes a little more careful observation on your part, you can really maximize your retirement savings by planning the best years to pay taxes on your IRA. Many people debate whether the traditional or Roth account is better (although if you only stick with one, the results are a gamble). The truth is you don’t have to gamble with how much you pay in taxes. You can, and should, decide when you are ready to pay the taxes on your retirement account.