Tax Angle #3: Optimize The Payoff From Converting An IRA To A Roth

A series of strategies for tax-wise investors. Table of Contents.

You can prepay income tax on some of your IRA, making future withdrawals tax-free. This is very clever if (a) your tax bracket is fairly low at the moment, and (b) you can cover the tax bill with money from outside the account.

Since conversions cannot be undone, it’s a good idea to do some calculations before taking the plunge. Use your tax software to see what the extra income will do. Here’s just one peculiarity: The 3.8% Obamacare surtax ostensibly does not apply to conversion amounts, but in fact it does for certain unfortunate taxpayers.

How is that possible? The 3.8% hit applies to the lesser of investment income or the amount your joint-return income tops $250,000. Suppose you have $200,000 of salary income and $60,000 from capital gains and dividends. Only the last $10,000 of that investment income is now exposed to the surtax. But what happens if you toss a $40,000 conversion into the mix? The conversion amount counts as income, so your adjusted gross climbs to $300,000. That boosts an incremental $40,000 of investment income into surtax territory. When the dust settles you have, in effect, paid a 3.8% tax on your conversion.

Roth accounts have benefits not only for the account owners but potentially for their heirs as well. The heirs get the money without owing income tax on it. The prepayment of income tax, moreover, is itself a nice gift from the original owner, and this tax asset appears nowhere on any gift or estate tax return.


The Secure Act of 2019 tightened rules on inherited IRAs, including Roth IRAs, but even now the heirs can take their time (ten years) liquidating an account. I have illustrated the value of Rothifying with a calculator that you can download from Roth Strategy After the Secure Act: Calculate Your Benefit. The short answer is that Rothifying pays off surprisingly often.

But what is the risk that a Democratic Congress will change the law? Low, if only for the cynical reason that the U.S. Treasury is hauling in a lot of up-front money from Roth savers. If legislators double-crossed early payers by making them pay again on exit, they’d instantly kill the revenue stream from voluntary conversions.

A lesser reform scheme might involve adding a mandatory withdrawal rule, now absent from Roth accounts. Forced liquidation would bring in only a small sum, possibly not even enough to offset the damage caused by a reduced willingness of taxpayers to play the game. I’d bet against this.

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