Making Lemonade from Lemons: Using Business Losses to Offset a Roth IRA Conversion

Published:

Authors:
Howard Essner, JD, General Counsel, Family Wealth & Retirement Plan Advisor


From time to time, we come across a client who has incurred business losses as a sole proprietor or through passthrough entities, such as an LLC or S-Corp. If the client is actively involved in the business, such losses can be used to offset other taxable income, such as wages, investment income, pension distributions, etc. Occasionally, the losses are large enough to wipe out the client’s entire taxable income with excess losses carried over to the next year (or carried back). While such losses are unfortunate, they can create an opportunity to do a “tax-free” Roth IRA conversion. What is a Roth conversion? A Roth conversion is simply the transfer of assets from a Traditional IRA to a new or existing Roth IRA. The amount transferred (i.e., converted) is treated as a taxable distribution from the Traditional IRA and therefore subject to tax as ordinary income. In the situation described above, the operating business losses exceeding the client’s other taxable income can be used to offset the taxable income created by the Roth conversion, resulting in a potentially “tax-free” conversion. In the right circumstances, this tactic can create significant future tax savings for the client.

Why consider a Roth conversion? A Roth IRA allows tax-free withdrawals on contributions plus gains, as long as certain age and holding period requirements are met. (Contributions to the Roth can always be withdrawn tax-free at any time). When a client holds both Traditional and Roth IRAs, distributions from the two sources can be managed to optimize the client’s marginal tax rate. Moreover, Roth IRAs are not subject to the Required Minimum Distribution (RMD) rules applicable to Traditional IRAs. If the client does not need the Roth IRA assets to support living expenses, then he or she can leave the Roth IRA intact, providing a wonderful tax-free legacy to his or her family. (As a side note, clients who are subject to the federal estate tax might consider a Roth conversion even without offsetting business losses.)

Clients are also allowed a “second bite at the apple” when converting to a Roth IRA if they change their mind. A Roth conversion can be undone at any time up to the due date of the tax return associated with the year in which the conversion took place (October 15, if an extension is filed.) Thus, if the client’s tax situation in the following year has changed, the Roth conversion can be undone, and the excess business operating losses applied to the next year’s income.

It is important to note that the business losses discussed in this article must be from a business in which the client actively participates. Passive activity losses (losses from business in which the client does not actively participate) can only be used to offset passive activity income or gains and cannot offset other income, such as from the Roth conversion. Likewise, capital losses (losses from the sale of an asset such as stock, real estate, equipment or a business) must first be used to offset capital gains. While $3,000 of capital losses can be used to offset other income, this provides little opportunity for a Roth conversion.

Please contact your Ancora advisor for more information.

 

Additional Note: A Year-End Charitable Giving Strategy

If you are considering year-end charitable gifts, have a Traditional IRA, are over age 70 ½, and have not yet taken this year’s RMD, you should consider using your IRA to make these contributions. Doing so can provide significant tax savings in the right circumstances. Please contact your Ancora advisor for more information.


Howard Essner, JD, is the General Counsel, managing director, family wealth advisor at Ancora Holdings Inc


The mention of specific securities, types of securities and/or investment strategies in this newsletter should not be considered as an offer to sell or a solicitation to purchase any specific securities or to implement an investment strategy. Please consult with an Ancora Investment Professional on how the purchase or sale of specific securities can be implemented to meet your particular investment objectives, goals, and risk tolerances. Past performance of these types of investments is not indicative of future results and does not guarantee dividends/interest will be paid or paid at the same rate in the future. The data presented has been obtained from sources that are believed to be accurate and credible. Ancora Advisors makes no guarantee to the complete accuracy of this information. The indexes discussed are market performance indices and are not available for purchase. If you were to purchase the securities that make up these indices, your returns would be lower once fees and/or commissions are deducted. Past performance of these indices is not indicative of future results of the securities contained in these indices.

Ancora Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States. A more detailed description of the company, its management, and practices are contained in its “Firm Brochure” Form ADV, Part 2a. A copy of this form may be received by contacting the company at: 6060 Parkland Blvd, Suite 200, Cleveland, Ohio 44124, Phone: 216-825-4000, or by visiting our website www.ancora.net/adv

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