Many believe the best time for crucial tax planning is in December, but October is often the sweet spot for Roth conversions.
A Roth conversion gives you the power to pay taxes now, at a rate you can project and manage, in exchange for the potential for a lifetime of tax-free growth (if qualified).
In true October form, we’ll sort through some common misconceptions, or “tricks,” to uncover the strategic truth, or “treats,” associated with this strategy.
The Q4 Sweet Spot: A Tactical Advantage
By October, the vast majority of your annual income is known, including compensation, capital gains, and business distributions, creating clarity that helps your financial advisor model the conversion tax liability more accurately. We can work to determine the dollar amount that maximizes your current tax bracket without pushing your Modified Adjusted Gross Income (MAGI) into a more expensive marginal bracket.
This quarter also offers a unique opportunity if markets experience volatility. If investments are temporarily down, you convert the same number of shares at a lower dollar value. This allows you to pay less tax for the same long-term growth potential. That tax-free upside, when the market recovers, is secured for future tax-free growth.
Now let’s get into three misconceptions about Roth conversions:
- The IRA Can Pay Its Own Tax Bill
The Trick: That the tax due on the conversion can simply be withheld from the traditional IRA funds being converted. The biggest conversion mistake is using the retirement account itself to pay the tax. Doing so instantly reduces the principal amount that enjoys tax-free growth, and if you are under the age of 59½, that withdrawal may incur an additional 10% early distribution penalty.
The Treat: Paying the conversion tax with cash or assets from an outside taxable account keeps the full value of the conversion working for you inside the Roth, ensuring every dollar of future growth remains potentially tax-free (if qualified). This may be your best defense against future, unknown tax legislation.
- You Must Convert Everything in One Go
The Trick: Converting too much in a single year can trigger severe unintended consequences that wipe out your tax savings. A large conversion can cause income stacking, which pushes your total income into a higher marginal tax bracket and can trigger unexpected surcharges, like the Income-Related Monthly Adjustment Amount (IRMAA) for Medicare.
The Treat: A strategic plan often involves smaller, multi-year conversions, or a controlled drip, to systematically fill lower tax brackets over several years. This measured approach helps manage your total liability and prevents an income spike from causing unintended penalties, to help maximize the long-term tax efficiency of the strategy.
- Your Converted Money Is Locked Away for Decades
The Trick: It’s a misconception that once money is converted, it’s inaccessible for the next 20+ years. This myth is based on confusing the two different five-year rules, which causes fear and often leads to beneficial conversions being delayed or avoided entirely.
The Treat: The original converted amount (the principal) can generally be withdrawn penalty free five years after the conversion (or if you are over age 59½). Only the earnings must meet both the five-year-account-holding and age 59½ requirements to be fully tax-free and penalty free. This flexibility means a successful household can maintain access to converted principal if truly needed, while creating a powerful, potentially tax-free financial legacy for future generations.
Conquering the Tax Tricks for a Clear Future
Acting strategically in the fourth quarter helps create greater flexibility and visibility into your future tax situation.
Don’t let the fear of complex tax rules delay a decision that could dramatically impact your long-term wealth. Connect with your SignatureFD financial advisor in Atlanta today to run a tax projection and work to secure a future of tax-free growth.
