Converting a large amount like $865,000 to a Roth IRA is a strategic move to achieve long-term tax benefits — including tax-free retirement income and eliminating required minimum distributions (RMDs) — but it often comes with a large upfront tax bill. Transitioning from a traditional IRA or 401(k) to a Roth IRA means paying taxes on the converted funds. But with careful planning and strategic execution, it’s possible to minimize the tax impact. Here’s how you can do it.
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Understand the Basics of Roth IRA Conversions
When you convert money from a traditional IRA or 401(k) to a Roth IRA, you are essentially converting tax-free dollars into taxable dollars. This conversion triggers a taxable event, meaning you must pay income tax on the amount converted. The key to minimizing taxes is understanding the timing and the amount.
Strategy 1: Partial conversions over several years
Instead of transferring the entire $865,000 in one year, consider spreading it out over several years. This strategy will help you avoid getting into a higher tax bracket. For example, if you’re currently in the 24% tax bracket, converting a large amount could cause you to fall into the 32% or 35% tax bracket, significantly increasing your tax liability.
Example strategy:
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Year 1: Convert $200,000
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Year 2: Convert $200,000
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Year 3: Convert $200,000
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Year 4: Convert $200,000
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Year 5: Convert $65,000
By stretching out the conversion, you keep your taxable income lower each year and can potentially save thousands in taxes.
Keep in mind that any converted amount is usually subject to the five-year rule. This means that you cannot withdraw the converted amount without penalty for five years after the conversion.
A financial advisor can help you develop a customized conversion strategy to minimize your conversion taxes. Speak to an advisor today.
Strategy 2: Use years with lower income
If you anticipate a year of lower income—for example, in retirement or during a sabbatical—this could be the ideal time to convert (though you may have to wait five years to use that income). In a year of lower income, your total taxable income is lower, meaning the rollover amount will be taxed at a lower rate.
Example scenario: If you plan to retire at 62 and start taking Social Security at 67, the years between 62 and 67 may be the best for Roth conversions. With no earned income and delayed Social Security, your taxable income is lower, allowing for a more tax-efficient rollover.
Strategy 3: Use tax deductions and credits
Take advantage of available tax deductions and credits to offset your rollover tax liability. Charities, medical expenses, and business losses are examples of deductions that can reduce your taxable income.
Example tactics:
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Donation amount: If you itemize your deductions, you can offset the increased taxable income from large donations in the same year you make your transfer.
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Medical expenses: If you have significant medical expenses that exceed 7.5% of your adjusted gross income, these can also be deducted, reducing your taxable income.
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Business losses: If you own a business, operating losses may be able to be used to offset your taxable income from the transfer.
Strategy 4: Contribute to a Health Savings Account (HSA)
Contributions to an HSA can help lower your taxable income. HSAs offer triple tax benefits: contributions are tax-deductible, growth is tax-free, and withdrawals for qualified medical expenses are tax-free. Maximize your HSA contributions to lower your overall taxable income.
Strategy 5: Convert during market downturns
When the market is down, the value of your traditional IRA or 401(k) investments may be lower. Converting during a downturn means you’ll roll over a smaller amount and thus have a smaller tax burden. Additionally, any subsequent growth within the Roth IRA will be tax-free.
Advice from a financial advisor
Given the complexity of the tax laws and the significant amounts involved, consulting with a financial advisor or tax professional is essential. They can help you develop a strategy specifically tailored to your financial situation and goals so you maximize benefits while minimizing tax burdens. If you’re looking for a fiduciary financial advisor, this free tool can match you with up to three advisors.
The conclusion
Rolling over $865,000 to a Roth IRA is a smart financial move that offers long-term tax benefits but requires careful planning to avoid a large tax bill. By spreading the conversion over several years, taking advantage of lower-income years, using tax deductions and credits, contributing to an HSA, and converting during market downturns, you can strategically minimize your tax liability. Consult a financial advisor to develop a personalized plan that fits your financial goals.
Retirement planning tools
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How much money do you need for retirement? Find out with SmartAsset’s retirement calculator.
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Have an emergency fund ready in case unexpected expenses arise. An emergency fund should be liquid – in an account that is not exposed to the risk of large fluctuations like the stock market. The downside is that the value of liquid cash can be eroded by inflation. However, a high-yield account allows you to earn compound interest. Compare savings accounts from these banks.
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