Manage the cost of a conversion:
✔ Consider spreading the cost over a few years.
✔ It might be helpful to undo some or all of the conversion.
✔ Consider making a charitable contribution to offset the tax cost, and using a donor advised fund.
The benefits of a Roth IRA are clear—the potential for tax-free growth and tax-free withdrawals.1 But not everyone may be able to contribute to a Roth IRA because of IRS-imposed income restrictions on contributions. But anyone can convert existing money in a traditional IRA or other tax-deferred retirement savings account to a Roth IRA. And many do.
A Roth IRA conversion does have a cost. Income taxes need to be paid on the converted amount. Taxes are “front-loaded,” which then gives the money in the Roth IRA the potential to grow tax free. It also ensures tax-free withdrawals for the Roth IRA owner or his or her heirs.
Here are two ways to help manage the taxes. One even does some good by combining the conversion with a charitable deduction.
Spread the cost
A common way to manage taxes on a Roth IRA conversion is to spread the conversion over a few years. This spreads the taxes too, and it may also prevent the income from the conversion causing a bump into a higher tax bracket.
Consider this hypothetical example: Imagine a married couple, the Mullens, who expect to file jointly with $100,000 in taxable income. They could convert up to $50,000 to a Roth IRA and stay within their current tax bracket, which applies to taxable income between $90,000 and $150,000. (Note: This is a hypothetical bracket for this simplified example only; actual tax brackets will differ, and they may change from year to year). As long as their tax rate and income generally stay the same, they could convert this amount yearly until they reach the total amount they want to convert. The potential benefit is that they maintain a consistent tax rate when converting (provided their situation and the tax rates don’t change in the ensuing years.) If they converted more than $50,000, any amount over the current marginal rate income range would be taxed at the next higher marginal rate. Things aren’t always as simple, however, as they are in this example. For higher-income filers, for instance, phaseouts on itemized deductions and personal exemptions can make computing taxable income more complex.
Managing the tax impact of a Roth IRA conversion requires careful analysis. A review with a financial or tax adviser is a good idea.
Other things to consider
A conversion must be completed by December 31. Estimating taxable income may be tricky without all tax reporting documents, which typically aren’t available until well after December 31. So taxable income may end up being higher or lower than expected.
A solution to consider: a recharacterization. It “undos” some, or all, of a conversion made the prior year. Typically a recharacterization must be done by October 15 of the year following a conversion.2 For example, say after they converted $50,000 to a Roth IRA, the Mullens discover in January of the following year that their income was higher than they expected. Because of that, $10,000 of the conversion ended up being taxed at a higher rate instead of their current one. They could recharacterize that $10,000 to bring their total taxable income back into their current bracket. Some recharacterizations save more than others, and because they do involve paperwork, it’s a good idea to do the math and make an informed decision. For the Mullens, recharacterization (followed by another conversion in a later year, when their income is lower) would save $500 if the tax rate to which they'll be subject on the $10,000 is five percentage points higher than their current bracket.
Another challenge: For those near the top of their bracket, it may take a long time to convert the total amount wanted without moving into a higher bracket. For example, for joint filers with $100,000 taxable income, the next bracket begins at $110,000. Converting only $10,000 would keep the filers within the same bracket.
Consider a charitable contribution
Tax deductions can help offset the tax cost of a Roth IRA conversion and perhaps allow conversion of a larger amount at a lower tax cost. Among the more flexible of deductions, especially for high-income earners, are charitable contributions.
The tax deduction for a contribution to a public charity can be up to 50% of adjusted gross income (AGI) for cash donations and up to 30% for donations of securities (generally deductible at fair market value when long-term appreciated securities are gifted) in a given year. And if a contribution exceeds these limits, the excess can generally be carried forward for up to five years. (Note: These limits are generally applicable, but there are exceptions, and the rules are complex. Consult a tax adviser when considering a large charitable contribution.)
The amount of the charitable deduction available to claim, can generally be estimated by adding the taxable portions of a conversion amount to AGI. For example, for those planning to convert $200,000 to a Roth IRA, with a $150,000 AGI before the conversion, the estimated AGI would be $350,000 after the conversion. Up to $175,000 (50% of $350,000) of a charitable cash contribution or $105,000 (30% of AGI) of a charitable donation of securities with long-term appreciation, could potentially be deducted. This could significantly reduce the tax impact of a conversion.3
Consider this hypothetical example (shown right): Richard and Ellen Nettle are considering a large Roth IRA conversion. They have $500,000 in an eligible rollover IRA and $500,000 in a taxable brokerage account—which could be used to pay the taxes on the conversion, or to make a charitable donation. The couple expects that in the coming years their income will be higher, pushing them into a higher tax bracket, so they’d like to convert $100,000 from their rollover IRA at the lowest possible tax cost as soon as possible. The Nettles regularly give to charity and could make a $100,000 one-time gift to charity this year from their taxable brokerage account. The couple expects $300,000 in AGI this year. If they made a charitable contribution of $100,000 of securities from their taxable brokerage account, they could deduct it from their income. The Nettles' combined federal and state/local income tax rate of 40% would apply to the $100,000 Roth conversion, so it would cost them $40,000, which they could offset entirely with their $100,000 contribution.
So the Nettles could save $40,000 in taxes if they make a charitable donation the same year they convert. However, they would need to be able to afford the $100,000 charitable donation—an important consideration. On the other hand, if the $100,000 that the Nettles gave to charity included securities with long-term appreciation, by gifting the securities, the Nettles also avoid taxes on the realization of those gains.4 In some cases that can significantly reduce the effective after-tax cost of a charitable contribution.
This is a simplified example. Phase-outs of itemized deductions can change the calculations, as well as limitations on charitable deductions based on the type of charity. For these reasons, it’s important to speak with a tax adviser as part of a Roth IRA conversion decision.
Consider a donor-advised fund
What if someone prefers giving regularly rather than making a single large gift to charity when he or she converts to a Roth IRA? It may make sense to consider a donor-advised fund, or DAF. DAFs, which are programs offered by public charities, allow a charitable contribution to be made in a given year, and a tax deduction for that year. Then, at a later time, grants can be recommended from the DAF to the charities a person wishes to support. The tax deduction can be taken in the year the Roth conversion was done to help offset the conversion taxes and still continue supporting charities over several years. With a DAF, a “ready reserve” of charitable dollars is front loaded that can be used over time to support many charitable causes.
Some challenges to the charitable-offset strategy: Gifts to charity are irrevocable. Unlike Roth conversions, which can be “undone,” or recharacterized, gifts to a charitable organization, including DAFs, are final. So for those who decide to recharacterize a Roth conversion would need to determine how much of the charitable donation was deductible for that year and how much may need to be carried forward to other years. It also might be at a lower tax bracket than expected. Also, charitable deductions may be worth more if taxes go up in the future, because they may be deducted against a higher tax rate.
Managing the tax impact of a Roth IRA conversion requires careful analysis. Ideally, it should include a review with a financial or tax adviser to fully investigate the benefits from a Roth IRA conversion and how to execute it appropriately.
This information is intended to be educational and is not tailored to the investment needs of any specific investor.
Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.
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