So how do you not lose money on an IRA conversion? There are a couple of ways.
Converting Non-Deductible IRA Funds
The easiest way to escape paying taxes on an IRA conversion is to make traditional IRA contributions when your income exceeds the threshold for deducting IRA contributions, then converting them to a Roth IRA.
If you’re covered by an employer retirement plan, the IRS limits IRA deductibility. For 2019, if you’re single, an IRA contribution is no longer deductible when your income reaches $74,000. If you’re married filing jointly, the limit is $123,000.
In order to be able to contribute directly to a Roth IRA, your income can’t exceed $137,000 for singles and $203,000 for married filing jointly. However, there’s no income limit on Roth IRA conversions.
If you’re married and you make more than $123,000 (the IRA deductibility limit) you can make a contribution to your traditional IRA, then roll it over to a Roth IRA. If you do this immediately — as in before the traditional IRA has a chance to accumulate investment income — the rollover will take place without any income tax consequences, as long as you have no other traditional IRA balances.
What if you do have existing IRA balances? You can try to make them go away…
Leveraging Your 401(k) Plan
Some employer 401(k) plans will allow you to roll your traditional IRA accounts over into the plan. If they do, you can convert your existing IRA accounts to your 401(k). In doing so, you will no longer have IRA money, and you will no longer be required to apportion your Roth rollovers based on a percentage of your nondeductible IRA contributions. All-new, non-tax-deductible traditional IRA contributions can then be converted into Roth IRAs without tax consequences.
But what if your employer 401(k) doesn’t permit IRA rollovers?
If Your 401(k) Doesn’t Permit IRA Rollovers
The insurance industry has rolled out new products in recent years in order to make their annuities more competitive with other investment vehicles. One that is particularly interesting in connection with IRA conversions is the bonus annuity. These are annuities that pay you an upfront bonus of between 2% and 10% of the amount of the annuity.
Much like IRAs, annuities have the advantage of being tax-deferred. A bonus annuity can offset the taxes paid on a partial IRA conversion.
For example; let’s say you have $200,000 in your IRA, and you want to roll part of it into a Roth IRA. If you move the entire balance of the plan into a bonus annuity IRA that pays a 7% bonus on the balance, that will be $14,000 in “found money”, which can be used to offset the taxes on the portion that will be converted to a Roth IRA.
If you are in the 28% tax bracket, you will be able to convert $50,000 of your IRA into a Roth without losing money. The rollover will result in a $14,000 tax liability ($50,000 X 0.28), but that will be offset by the 7% bonus that you will be paid on the $200,000 rollover to the annuity — which will be $14,000 ($200,000 X 0.07). You still have to pay the tax on the partial conversion, but that is covered by the bonus you receive on the total rollover.
Annuities aren’t the best investment choice for everyone. They do come with certain restrictions and are usually packed with fees. In fact, the primary purpose of a bonus annuity is to cover surrender charges in the event that you decide to terminate your annuity before the contract allows you to do so without penalties.