You can't avoid taxes when making a Roth IRA conversion, but there are strategies to reduce your tax burden if the circumstances are right.

When you convert money from a pre-tax account, such as a 401(k) or an IRA, to a post-tax Roth IRA, you must pay income taxes on the full value of the transfer. The advantage to converting to a Roth IRA is that withdrawals will be tax-free throughout your retirement. But this may only be worth it if your tax burden on the conversion doesn’t outweigh the benefit.

Need help minimizing taxes and planning for retirement? Get matched with a financial advisor today.

Eligibility for Roth IRA Conversions

In general, you can move funds from any qualified retirement plan to a Roth IRA.

Unlike contributions, there are no household income limits on a Roth IRA conversion. This has led to what is called a "backdoor conversion," in which high-income households contribute to a traditional IRA then convert that money to a Roth IRA. This is legal and effective, but if done repeatedly it will trigger some additional taxes known as the "pro-rata rule."

While your 401(k) would incur taxes with each withdrawal made in retirement, Roth IRA withdrawals beyond age 59.5 are not taxed. Therefore, if you have time left for your assets to grow, or expect to have a higher tax rate in retirement than you do currently, converting to a Roth IRA may net you a more in retirement. However, if you are already very near retirement or expect to have a lower tax rate when you make withdrawals, the conversion may not be worth it.

Roth IRA conversions go one way. You can convert a pre-tax account to a Roth account, but cannot convert a Roth account to something like a traditional IRA or 401(k). This is particularly important because it means that you cannot unring this bell once you get your tax bill. Once you make a conversion, you must deal with the taxes.

Talk to a financial advisor to figure out a suitable strategy to maximize your retirement income.

How to Minimize Taxes On Your Roth Conversion

Here, you have $500,000 that you would like to convert to a Roth IRA.

If you are holding this money in a Roth 401(k), then you will not owe any taxes on that transaction. These are both post-tax accounts, so you can execute a rollover or transfer with no tax event.

If you are holding this money in a pre-tax account, such as a 401(k) or IRA, it gets more complicated. When you move this money, you will add the full value of the transfer to your taxable income for the year. Here, for example, you would add up to $500,000 to that year's AGI.

As a result, it's often wiser to make a large conversion in staggered, smaller amounts so as not to trigger a huge tax bill and higher tax brackets in a given year. Converting $500,000 in a single year could potentially push your total AGI into the highest federal tax bracket (37% in 2023, plus any applicable state and local taxes). However, if you have time to spread the conversion out over, say, five years, adding $100,000 each year to your AGI may keep you in a lower tax bracket. Depending on how you file taxes and the corresponding thresholds, you could save tens of thousands of dollars with this strategy.

A financial advisor can help you determine the best strategy for your assets.

Weighing Your Anticipated Retirement Date

Beyond that, the biggest issue is when you anticipate retiring.

A Roth IRA is one of the most useful tax-advantaged retirement accounts on the market, but that value depends largely on having enough time to make big, untaxed gains. If you plan on retiring in the next few years, you probably won't see much in tax-free Roth gains to offset the tax bill from the conversion.

It's also important to consider your planned retirement income and tax bracket.

The difference between a pre- and post-tax account is when you pay your taxes. With a Roth account you pay up front, with a 401(k) or IRA you pay when make your withdrawals. So a Roth portfolio can lose some advantages if you pay a much higher tax rate while working than you will once you have retired.

For example, say that you currently pay a 20% effective tax rate and anticipate a 10% effective tax rate in retirement. You might pay $100,000 on the conversion (0.2 * $500,000) vs. $50,000 over time on the withdrawals (0.1 * $500,000).

Now, this is just by way of example. Taxes in reality are much more complicated, but it serves to illustrate the point. If you have the time for your Roth IRA to grow significantly and you expect to be in a comparable tax bracket once retired, this might be a wise conversion. If you do not have time for this account to significantly grow and/or you expect to be in a significantly lower tax bracket in retirement, you might actually pay more on a Roth IRA conversion in the long run.

Remember, if you need help with taxes or a retirement strategy, you can get matched with a personal financial advisor.

Bottom Line

You cannot avoid paying taxes on a Roth IRA conversion. This is a post-tax account, so you must pay income taxes on the money you put in. For large retirement accounts, this makes a conversion complicated. It can be a good idea if you have the money to pay that bill and the time for your account to grow, but be careful not to trigger more taxes in the long run.

Roth IRA Management Tips

• It's easy to consider Roth IRAs the golden goose of retirement, and for most people this really is the best product on the market. Still, it’s important to consider both the pros and cons of investing in Roth IRAs.

• A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.

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