With uncertainty surrounding future tax rates, Roth conversions have emerged as a hedge against this risk by providing tax-free income in retirement. The downside is that typically a conversion leads to a higher tax bill today. However, there may be planning opportunities or circumstances to mitigate taxes associated with a Roth conversion.
1. Make the most of a business-related loss
Certain pass-through business owners (sole proprietors, LLC members and S-Corp business owners) may be able to apply tax losses from business operations to offset ordinary income on their personal tax returns, including income from a Roth IRA conversion. A net operating loss (NOL) may occur during a tax year when business deductions exceed income, resulting in negative income. While business owners would prefer to avoid losses, sometimes realizing a business loss is inevitable given economic or personal circumstances. Under current tax rules a NOL, if generated, generally must be carried forward to future tax years. Subject to applicable tax rules and limitations, business losses may help offset income generated from a Roth conversion, potentially reducing the current tax cost while creating a source of tax-free retirement income in the future.
For a sole proprietor, business income and expenses are reported on Schedule C, which is used to calculate net business profit or loss. This figure is then carried over to the taxpayer’s 1040 form and combined with other income (spousal income, unearned income from investments, etc.). Generally, if allowable deductions exceed income after applying applicable tax rules, a NOL may result.
For other pass-through business entities, such as an S-Corp, partnership or LLC, the calculation of an NOL is more complicated. In these cases, a business loss for a particular year is first applied to the taxpayer’s cost basis in the business. Once the basis in the entity is reduced to zero, an NOL may apply. Additionally, entities generating passive income (from real estate activities, for example) are subject to the passive loss rules and may be limited when calculating a deduction for a net operating loss.
Source: IRS Publication 536, Net Operating Losses (NOLs) for Individuals, Estates and Trusts. The Tax Cuts and Jobs Act (TCJA) introduced changes to the tax treatment of net operating losses (NOLs). Since 2018, taxpayers are no longer able to carry back NOLs, but instead, must carry forward NOLs for an unlimited number of years. Taxpayers are allowed to deduct NOLs only up to 80% of taxable income in that year, and additional limits may apply due to the excess business loss provision. For 2026, the excess business loss limitation is $256,000 for single filers and $512,000 for married couples filing a joint tax return. Consult with a qualified tax professional for more information on NOLs.
2. Leverage significant medical expense deductions
Under current rules, unreimbursed medical expenses can only be deducted from income if total (deductible) medical expenses exceed 7.5% of adjusted gross income (AGI). For example, consider a taxpayer with AGI equal to $100,000 and unreimbursed medical expenses totaling $10,000. For that tax year, a deduction for $2,500 would be available. Only the amount that exceeds $7,500 (7.5% of AGI) may be deducted in this example. While this may be a high threshold for many taxpayers, older individuals with significant medical and health-related expenses and lower income levels may be able to realize a large deduction for unreimbursed medical expenses.
Consider unreimbursed long-term care expenses. If the individual is in a nursing home primarily for medical care, then the entire nursing home cost (including meals and lodging) is generally deductible as a medical expense. If the individual is in a facility primarily for nonmedical reasons, then only the cost of the actual medical care is deductible as a medical expense, and not the cost of meals and lodging. Significant medical expenses may help offset income from a Roth IRA conversion.
Consider this example:
- Claire is an 85-year-old woman residing in a skilled nursing home facility with out-of-pocket medical expenses totaling $120,000 a year. She is paying for nursing home care from her savings and income she receives from required IRA distributions, Social Security and other sources.
- Since she resides in the nursing home primarily for medical care, costs including lodging and meals (in excess of 7.5% of AGI) are deductible on her tax return.
- Her AGI is $60,000 annually.
- She has an IRA valued at $500,000 consisting entirely of pretax funds.
- Given her medical expenses, she may be able to convert a portion of her traditional IRA to a Roth IRA while generating little or no additional federal income tax liability, depending on her overall tax situation. Depending on her circumstances, Claire could leave the Roth IRA to heirs as a tax-efficient wealth transfer.
For more information on deducting medical expenses, consult IRS Publication 502, Medical and Dental Expenses. Actual tax results will depend on factors including other sources of income, itemized deductions, state income taxes and the taxation of Social Security benefits.
3. Charitable contributions
Those considering substantial gifts in a particular year may have a large deduction available to offset ordinary income. However, there are limits on claiming a charitable deduction in a single tax year (maximum of 60% of modified adjusted gross income, or lower, depending on the nature of the property donated and the type of charitable organization). Generating additional income through a Roth conversion in a year when a large charitable gift is made may allow a taxpayer to make fuller use of available charitable deductions and potentially reduce the amount carried forward to future years. It may make sense to convert Traditional IRA assets to a Roth IRA during a year when large charitable gifts are made.
Since a Roth conversion cannot be undone, careful analysis and consultation with a qualified tax professional are critical.
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For more information on deducting charitable contributions, consult IRS Publication 526, Charitable Contributions.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and should not be construed as, investment advice, forecast of future events, a guarantee of future results, or a recommendation with respect to any particular security or investment strategy or type of retirement account. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.
Franklin Templeton, its affiliated companies, and its employees are not in the business of providing tax or legal advice to taxpayers. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any such taxpayer for the purpose of avoiding tax penalties or complying with any applicable tax laws or regulations. Tax-related statements, if any, may have been written in connection with the “promotion or marketing” of the transaction(s) or matter(s) addressed by these materials, to the extent allowed by applicable law. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.
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