How to Use a Partial Roth Conversion to Save on Taxes
Learn how strategically timing and sizing a Roth conversion allows for greater control over your lifetime tax obligations on retirement funds.
A partial Roth conversion is the process of moving a portion of your retirement savings from a pre-tax account into a post-tax Roth IRA. This action is a repositioning of existing assets, not a new contribution. The amount you move is included in your taxable income for that year.
Funds can originate from a Traditional or SEP IRA. Funds from a SIMPLE IRA can also be used, but the account must be at least two years old, starting from the first contribution date. Converting from a SIMPLE IRA within this two-year window subjects the distribution to a 25% penalty.
The converted funds are taxed at ordinary income rates, but qualified distributions in retirement are tax-free. By converting, you pay taxes on a portion of your funds now to avoid taxes on that money and its future earnings later. This differs from a full conversion, where the entire balance of a pre-tax account is moved and taxed in a single year.
Strategic Reasons for a Partial Conversion
The decision to undertake a partial conversion is often driven by tax planning, specifically the management of one’s marginal tax bracket. A full conversion of a large traditional IRA could significantly increase your income for the year, pushing you into a higher tax bracket. This would cause a larger percentage of the converted amount to be taxed at a higher rate.
By breaking the conversion into smaller, partial amounts over several years, you can control the amount of additional income you recognize each year. This strategy allows you to “fill up” your current tax bracket without spilling over into the next one. For example, if you are $20,000 away from the next tax bracket, you might choose to convert only $20,000.
This strategy is particularly effective during years of unusually low income. A year with a job change, a period of unemployment, or the start of an early retirement could place you in a temporarily lower tax bracket. Converting a portion of your traditional IRA funds during such a year allows you to pay taxes on the conversion at that lower rate.
Calculating the Taxable Amount
The taxable portion of a conversion is determined by the IRS pro-rata rule. This rule applies if you have both pre-tax and after-tax (nondeductible) contributions in any of your traditional IRAs. For this calculation, the IRS treats all your traditional, SEP, and SIMPLE IRAs as a single account, preventing you from converting only after-tax funds.
The calculation determines the proportion of your total IRA assets that consists of after-tax money. This percentage is then applied to the amount you convert to find the non-taxable portion. For example, imagine you have a total of $100,000 across all traditional IRAs, consisting of $90,000 in pre-tax funds and $10,000 in after-tax contributions (your basis).
If you decide to convert $20,000, you must first determine the ratio of after-tax money to the total balance. In this case, the $10,000 basis is 10% of the $100,000 total. Therefore, only 10% of the $20,000 conversion, or $2,000, is tax-free. The remaining 90%, or $18,000, is included in your ordinary income for the year.
This calculation must be performed each time a conversion is made. The values used for the calculation, specifically the total value of all traditional IRAs and the after-tax basis, are based on their balances as of December 31 of the year the conversion takes place.
Information and Decisions Before Converting
Before initiating a conversion, you must gather data and make key decisions.
- Find the total amount of your non-deductible, or after-tax, contributions made to your traditional IRAs, which is your cost basis. This information is tracked on previously filed copies of IRS Form 8606.
- Decide on the exact dollar amount you wish to convert, aligning with your strategic goals for managing your tax bracket.
- Create a plan for paying the resulting income tax. You can pay from a separate, non-retirement account or have taxes withheld from the converted amount.
- Be aware that withholding from the conversion reduces the amount that goes into the Roth IRA. If you are under age 59½, the withheld amount may also be subject to a 10% early withdrawal penalty.
The Conversion Process
The conversion process begins by contacting the financial institution holding your traditional IRA. Instruct them to move a specific dollar amount to a new or existing Roth IRA, which is known as a trustee-to-trustee transfer.
After you initiate the transfer, the financial institution will handle the movement of assets and provide confirmation statements. In January of the following year, you will receive IRS Form 1099-R from your financial institution. This form reports the gross distribution from your traditional IRA.
The final step is to properly report the conversion on your federal income tax return. You must file IRS Form 8606 with your Form 1040. This form is where you perform the official pro-rata calculation using the total value of all your IRAs as of December 31 of the conversion year. The taxable amount from Form 8606 is then carried over to your Form 1040 and included in your adjusted gross income.