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Roth IRA Conversion Strategy to Avoid Taxes

If you have money in a traditional IRA and want to take advantage of a Roth conversion, you need to know about the pro-rata tax treatment of conversions.

If you have both tax deferred and after tax money in a traditional IRA, you could face hefty taxes on the deductible IRA money, since you must convert a pro-rata [1] amount of deductible and non-deductible money.

If you want to convert just your after tax money, which is common when using a backdoor Roth IRA [2] strategy, you can use this Roth IRA conversion strategy to avoid taxes if your 401k provider allows transfers of IRA money. It’s one of our 11 Unusual Roth IRA Strategies [3].

Roth IRA Conversion Strategy to Avoid Taxes

When you make a Roth IRA conversion for your IRA you must include a portion of tax-deferred money in the IRA in proportion to the amount held.

If your 401k provider allows transfers of IRA money, you can transfer your deductible IRA money to your 401k. When you convert your remaining non-deductible money in your traditional IRA to your Roth IRA, it will be tax free!

Tax Free Roth IRA Conversion Steps

  1. Identify how much money in your IRA was (or will be) deducted on your taxes.
  2. Move your deductible IRA money to your 401k.
  3. Make a Roth IRA Conversion [4] with your non-deductible money.
  4. Report your conversion with 100% basis on form 8606.
  5. The conversion will be tax free.

Let’s say I have an IRA worth $100,000, with $50,000 (50%) tax deferred and $50,000 after tax. If I complete a conversion of $20,000 to a Roth IRA, I will be responsible for taxes on $10,000, or 50%. You cannot specify to convert only the after-tax money in the account.

If I used the strategy above, I would first move $50,000 of tax deferred money to my 401k. Then, when I make my $20,000 Roth IRA conversion, the taxable amount will be $0.

More Considerations

Which IRAs count? Don’t forget to account for all of your IRA money when you determine how you might make this work. All IRAs including rollover IRAs are considered one IRA for conversion purposes. The traditional IRA also includes your SEP-IRAs [5] and SIMPLE IRAs [6].

Add additional money. Before your conversion, you can also contribute to a non-deductible traditional IRA at your broker of choice [7] up to the IRA Limits [8].

Should you convert to a Roth IRA? To see if a Roth IRA Conversion makes sense for you, check out Should You Do a Roth Conversion? [9]

Don’t have a 401k? If you don’t have a 401k, or your current 401k provider doesn’t accept incoming money, you could establish a solo 401k [10] for the purpose of moving your deductible money in your traditional IRA.

Keep detailed records. If you do this, you need to keep very detailed records. For more see How to Track Your Roth IRA Contributions… and Why You Need To! [11]

Early retirement and Roth IRAs. This strategy sounds like a lot of work to move money into a Roth IRA…. why would you want to hassle? If you are considering an early retirement, the Roth allows much more flexibility in early withdrawals [12] than a traditional IRA. After a conversion, you only need to wait 5 years, then you can withdraw your conversion money tax free. A real benefit for anyone considering early retirement!

Avoid IRA fees. You can transfer your IRA to Scottrade [13] and stop paying fees. Whether your account is Traditional, Roth, SEP or Rollover, you won’t pay set-up, annual, custodial, inactivity or closing fees with Scottrade. Open a No-Fee IRA now [13]!

More on Roth IRAs