Using Capital Gains and Losses With a Roth IRA Conversion

Many analyses done with respect to Roth IRA conversions only come out to a positive outcome when the attendant tax on the conversion is paid from non-IRA sources.  For many folks this shoots down the entire prospect, as there is no available cash outside of IRAs and other investments to use to pay the tax on the conversion.  Taking the cash from the IRA in the form of a distribution can result in a 10% penalty, which can kill the whole plan.

One source of funds that you may not have considered is within your non-IRA investment accounts – especially if you have inherent capital gains and losses (even moreso if you have carried-over capital losses that wouldn’t otherwise be utilized readily).

Offsetting Gains With Losses To Produce Cash

Here’s how it works: You sell your “loss” positions, establishing a capital loss for tax purposes.  Then you can sell your “gain” positions in like amounts, giving yourself a tax-free source of cash, since the loss will offset the gain for taxation purposes.

For example – imagine that you have a $100,000 IRA that you’d like to convert.  Running the numbers, you’ve come to realize that the conversion will cost $25,000 to complete.  In addition to the IRA, you also hold some non-IRA money, in the form of two investments.  One of these investments has an inherent loss of $20,000, and the other has an inherent gain of $30,000.

By selling out of the “loss” position completely and selling just enough of the “gain” position to offset the tax loss you’ve realized, you have effectively created a tax-free source of income in the amount of $20,000.  This still leaves $5,000 if you’re planning to convert the entire amount.

After you’ve finished with your conversion activities (and after 30 days has passed so that you don’t run afoul of the wash sale rules), you can re-invest the leftover money in those same investments, keeping your allocation at least similar to what it was before.

At this stage you have three choices, assuming you don’t have an extra $5,000 laying around:

  1. You can choose to only convert a portion of your IRA – the amount that you can generate tax-free money to pay tax upon.  In our example, this would be $80,000.
  2. You can use more of the cash that you freed up from the sales of your non-IRA gain and loss holdings.
  3. You can convert the entire amount and take distribution of the additional $5,000 to pay the extra tax.  Actually you’d need to pull out $5,500 in order to pay the penalty on that amount that you’re distributing.

Of these three, I’d recommend option 2, which is the outcome where you complete the conversion of the entire amount without having to pay additional tax or penalty on the money that you’re using to pay the tax on the conversion.  Yeah, that last sentence belongs in a museum.  Happy converting!

About the author

Jim Blankenship, CFP®, EA

Jim Blankenship is the founder and principal of Blankenship Financial Planning, Ltd., a financial planning firm providing hourly, as-needed financial planning and advice. A financial services professional for over 25 years, Jim is a CFP professional and has earned the Enrolled Agent designation, a designation that qualifies him as enrolled to practice before the IRS. Jim is also a NAPFA-registered financial advisor, which designates him as a Fee-Only Financial Advisor.

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5 Comments

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  • Jim:
    Your response to Pat was confusing to me. Lets say I have a traditional IRA worth $300,000 and I have a non-IRA loss of $150,000. I would like to harvest the $150,000 loss and fund my Roth IRA by taking $150,000 from the traditional IRA and funding the Roth with that amount. Is this possible without incuring additional taxation and what are the mechanics of this operation?
    All the Best
    Paul

  • Find a tax loss generator to offset your Roth conversion gains. Also, after you are done doing this, go out an celebrate with a couple of beers.

  • Hi, Pat –

    Just reading your question makes my head spin, so believe me I know it’s confusing.

    Your cap loss can be used to offset only $3,000 of ordinary income per year, after offsetting any capital gains for the year. When you convert funds from a traditional IRA to a Roth IRA, this results in ordinary income, so up to $3,000 of that income can be offset by your net capital loss. Any cap loss remaining can be carried over and deducted in future years.

    The capital loss can not be used to offset capital gains in a traditional IRA – the traditional IRA is not taxed on capital gains. Formerly deducted contributions and gains on all contributions are taxed as ordinary income upon distribution.

    Hope this helps clear up some of the confusion –

    jb

  • I liquidated non-IRA stock positions this year resulting in a $49K capital Loss. I will not have any non-IRA capital gains to offset the loss. However, I intend to convert a tradional IRA to a Roth IRA this year. Will I be able to use the non-IRA capital loss to offset some of the taxes I will have to pay to convert to Roth IRA? Or will I be able to use the capital losses from my non-IRA to offset possible capital gains from the traditional IRA?
    Thank you.

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