With the stock markets well below recent all-time highs, now might be a great time to consider converting your IRAs and other retirement accounts to a Roth to benefit with decades of tax-free growth.

  • Start by figuring out how much post-tax dollars you have in your IRAs as of 12/31/21. If you’ve been tracking these IRA contributions correctly, you can find the total on the Form 8606 attached to your personal tax returns. If your Form 8606 is incorrect, try to recreate the post-tax contributions within your IRAs as best you can.
  • Next, tally up the value of all of your IRAs. Include your traditional IRAs, rollover IRAs, SEP IRAs and SIMPLE IRAs while omitting money already held in your Roth IRAs. Also exclude the value of all your non-IRA retirement accounts such as your work 401Ks, 403Bs, 457s, Keogh Plans, Profit Sharing Plans, and Solo 401ks since those accounts are employer sponsored retirement plans instead of Individual Retirement Accounts (IRAs).
  • Lastly, divide the total post-tax contributions sitting in your IRAs by the total value of all of your non-Roth IRAs to figure the percentage of the IRAs converted that will NOT be taxed.

 For Example:

 Let’s say you have $100k in your IRAs of which $25k represents post-tax contributions. In this scenario, 75% of each dollar converted will be taxed. Convert all $100k and you would pick up $75k of additional income. Convert just $20k and expect to pick up $15k ($20k * 75%) of additional income even through the amount converted is less than the total post-tax contributions in your IRA.

How to Minimize Taxes on a Roth Conversion

Have you made non-deductible contributions into an IRA over the years but are still reluctant to convert the IRA to a Roth due to the total value of your IRAs? One way around this pitfall is to first roll a chunk of your IRAs into your employer sponsored retirement accounts or your Solo 401k, and then convert the remaining balance to your Roth. Doing so reduces the denominator, and therefore, makes the Roth conversion much more tax efficient.

First check that your employer’s retirement plan accepts IRA rollover. If so, set up for a direct rollover from your IRAs into that 401k or 403b account, making it easier for the IRS to track that the money taken from your IRA was in fact deposited into your work retirement plan.

To figure out the amount to roll into your employer’s plan, look at the total post-tax contributions as reflected on your 2021 Form 8606. Make sure to also factor in 2022 non-deductible IRA contributions made. You then figure the maximum amount to roll out of your IRA by subtracting the total post-tax contributions available from the total of all your IRAs.

 For Example:

 Let’s say you have $100k in your IRAs of which $25k represents post-tax contributions. If you don’t want to pay any taxes on the Roth Conversion, first roll $75k out of your IRAs into your 401k or 403b plan at work or Solo 401k if you are self-employed. That will leave only $25k of post-tax dollars in your IRA that you can now convert tax-free into your Roth. (Please note that a Solo 401k is different from a SEP IRA.)

Maybe take this opportunity to convert a few extra dollars to your Roth. Yes, you will owe some taxes for 2022, but that will provide you with more money growing tax-free within your Roth until withdrawn.

One more warning – please be careful to review the investment options available within your work retirement plan as well as the underlying fees associated with those funds. Rolling money from an IRA held in a high quality, low-cost environment into a platform with a poor selections of mutual funds or with funds that come with high fees could easily cause this strategy to backfire the longer the money sits in those poor performing funds.