Some hard working individuals spent years stuffing money into pre-tax retirement accounts: 401(k)s, traditional IRAs, SEPs, the occasional defined benefit plan. That was the right call when you were in peak earning years and wanted the deduction.

The problem is that every one of those dollars is going to come out of the account someday fully taxable at ordinary rates. And required minimum distributions don’t care whether you need the money or not. They just show up at age 73 or 75 and push you into brackets you may not want to be in.

A Roth conversion is how you do something about that while you still have control over the timing. You voluntarily move money out of a pre-tax account, pay tax on it today at a rate you pick, and from that point forward the account grows tax-free, comes out tax-free, and never generates a required minimum distribution during your lifetime.

The math works when you can execute the conversion at a lower effective tax rate than you expect to pay when the money would otherwise come out.

Why the timing of a conversion matters so much

When you convert, the entire converted amount gets added to your taxable income for that year. Convert $200,000 out of a traditional IRA and you just added $200,000 of ordinary income to your return. If you were already sitting in the 32 percent bracket, a chunk of that conversion is going to hit at 35 percent, and you may even touch the 37 percent bracket.

On top of that you can trigger IRMAA surcharges on Medicare premiums, phase out certain deductions, and increase the tax on capital gains and qualified dividends by pushing them into higher brackets.  This is VERY important!

So the planning question is never really “should I convert.” It’s “when, and how much, and what can I pair it with to keep the rate down.” There are four setups we look for, and they often stack.

Setup #1: Converting into a market dip

This is the one that gets the most attention, and for good reasonespecially during turmoil. When the market is down, your pre-tax account is worth less in dollar terms, but the shares inside the account haven’t changed. If you convert during the dip, you pay tax on the lower dollar value, and then the recovery happens inside the Roth where you never pay tax on it again.

Quick example. You have a traditional IRA that was worth $1,000,000 at the market peak, holding 10,000 shares of a diversified ETF at $100 per share. The market corrects and the same 10,000 shares are now worth $75 per share, so the account is $750,000. You convert the entire account. You pay tax on $750,000 instead of $1,000,000. If the market recovers back to $100 per share, you now have $1,000,000 sitting in a Roth IRA, and that $250,000 of recovery happens entirely tax-free. At a 32 percent marginal rate you effectively saved $80,000 in tax by moving the conversion from the peak to the trough.

First, you don’t need to time the exact bottom. You just need the account to be meaningfully below where you expect it to be long-term. Second, you can convert in-kind, meaning the actual shares move from the traditional IRA to the Roth. You don’t have to sell anything, you don’t realize any gain inside the account, and you keep your position. Third, the Tax Cuts and Jobs Act eliminated the ability to recharacterize a conversion, so once you pull the trigger you can’t undo it if the market drops further. That’s why we tend to do these in tranches rather than all at once.

Setup #2: Offsetting a conversion with oil and gas intangible drilling costs

One of our favorites at Anomaly. Working interests in oil and gas wells are one of the few investments left in the Code that generate large, immediate, ordinary deductions. Intangible drilling costs typically run 75 to 85 percent of the total investment and are deductible in the year the well is drilled. Because a working interest is not a passive activity under Section 469(c)(3), those deductions are active and can offset any ordinary income on the return, including the income from a Roth conversion.

This is a powerful pairing when the numbers work. You write a check into a qualifying oil and gas program. A large percentage of that check comes back as a current year deduction. That deduction soaks up the income from a Roth conversion of roughly the same size. The net result is that you’ve moved pre-tax retirement dollars into a tax-free Roth without writing a big check to the IRS, and you’ve done it using money you chose to invest rather than money you had to send to Treasury.

Example. A client is sitting on a $2,000,000 traditional IRA and wants to start moving it to the Roth side. In a normal year they’re in the top bracket. They invest $400,000 in a direct participation oil and gas program in December with 80 percent IDCs, generating a $320,000 deduction in the current year. We pair that with a $320,000 Roth conversion. The conversion income and the IDC deduction largely cancel out on the front of the 1040. The client has $320,000 more in their Roth, a working interest that will produce royalty income for years, and their federal tax bill on the conversion portion is close to neutral.

Things to watch with this strategy. Oil and gas programs have real economic risk, and we won’t recommend one just because it produces a deduction. The investment has to make sense on its own merits. There’s also an AMT consideration on excess IDCs that we model before committing. And you need a general partner or working interest structure, not a limited interest, to get the active treatment. We vet the sponsor, the geology, and the economics before we put a client in one of these.

Setup #3: Offsetting a conversion with real estate losses

If you already run the Short-Term Rental Strategy or qualify as a Real Estate Professional, you have a tool most taxpayers don’t. Cost segregation studies and bonus depreciation on newly acquired properties can throw off very large paper losses in the year of purchase. Those losses are ordinary for tax purposes, and under the right fact pattern they are non-passive and can offset any other ordinary income on the return.

The Short-Term Rental angle (see other KBs)

A short-term rental with an average guest stay of seven days or less, where you materially participate, is not a rental activity under the Section 469 regulations. The losses it generates are non-passive. If you buy a property in the second half of the year, commission a cost segregation study, and elect bonus depreciation on the reclassified five, seven, and fifteen yearproperty, you can generate a paper loss that is large relative to the purchase price.

Example. You purchase a $1,200,000 short-term rental in the Smoky Mountains in July. Cost seg identifies roughly 25 percent of the basis as five and seven year property and another 10 percent as fifteen year land improvements, so about $360,000 of basis qualifies for bonus depreciation. At current bonus percentages that produces a first-year depreciation deduction well into six figures, layered on top of the normal 39-year depreciation on the remainder. You manage the property yourself, keep a time log, and meet material participation. That non-passive loss flows to page one of your 1040 and offsets a Roth conversion of similar size. You end the year with a new Roth balance, a new rental property, and not much of a federal tax bill.

The Real Estate Professional angle (see REPS guide)

If you or your spouse qualify as a Real Estate Professional under Section 469(c)(7), meaning more than half of personal services and more than 750 hours in real property trades or businesses, plus material participation in the rentals, then your long-term rental losses are also non-passive. That opens up the same offset opportunity against a Roth conversion, using a long-term rental portfolio rather than a short-term rental.

We usually see this work best in a year when a client is buying a property anyway, or doing a cost segregation study on a property purchased in recent years. You get to front-load depreciation you were going to take eventually, time it into the same year as the conversion, and move retirement dollars from the taxable-later bucket to the never-taxed-again bucket.

Setup #4: Converting in a naturally low-income year

Sometimes you don’t need a deduction strategy at all. You just need to recognize when a year is already going to be unusually low and use the empty space in your lower brackets on purpose.

The years we flag for clients include the year of a business sale where the gain is mostly long-term capital gain, so ordinary brackets are sitting wide open. Early retirement years between the date you stop working and the date you start Social Security and RMDs, often a five to fifteen year window. A sabbatical or transition year. The year after a major business loss. A year where a spouse steps away from work. Any year you expect a bonus or distribution to get pushed into the next calendar year.

In any of these, you get to choose how much income to create by choosing how much to convert. We model the brackets, find the top of the 12 percent bracket and the top of the 24 percent bracket (or wherever the next meaningful jump sits for your situation), and fill to the line. You don’t have to convert the whole account. Partial conversions done every year for several years often move more money to the Roth side at a lower blended rate than one big conversion ever could.

Example. A biz owner sells their business in March for a large long-term capital gain. Their ordinary income for the rest of the year is modest because they’re not drawing a W-2 anymore. The long-term gain stacks on top of ordinary income, but it doesn’t itself fill the ordinary brackets. We run the numbers and find that they have roughly $180,000 of space before they’d push into the 24 percent bracket on ordinary income. We convert $180,000 from their traditional IRA at an effective rate in the low teens. We repeat the exercise for the next several years until RMDs or Social Security start, moving a meaningful chunk of the traditional balance to the Roth side at rates that would be impossible to access during their working years.

Stacking these together

These setups aren’t mutually exclusive. The best conversion years we see for clients tend to involve two or three of them at once. A market correction hits in the same year a client buys a short-term rental and also has a lower W-2 because they transitioned roles mid-year. That’s when we’re on the phone telling them to convert aggressively. The depressed account balance, the cost seg loss, and the lower baseline income all work in the same direction, and the conversion can be sized much larger than it could in a normal year.

The flip side is also true. Some years we tell clients not to convert at all, or to convert very little. A big bonus year, a year with a large distribution from a profits interest, or a year where a K-1 is going to come in heavy are not the years to voluntarily add more ordinary income. We’d rather wait.

A few mechanics worth knowing

How we approach this at Anomaly

Every year we look at the conversion question fresh for the clients it applies to during the Concierge Tax meeting in Q2/Q4. We pull the prior year return, project the current year, identify any of the four setups described above, and run a bracket-by-bracket model of what a conversion costs at different sizes.

If you think any of these setups describe your year, don’t wait until December to bring it up. Oil and gas programs have cutoff dates. Real estate purchases need to close and be placed in service before year end. Cost segregation studies take time. And market dips don’t announce themselves on a schedule.

The clients who get the most out of this strategy are the ones who tell us early when something has changed in their financial picture, so we have room to actually plan.