How to Convert to a Roth Tax Free

How to Use a Net Operating Loss (NOL) to Convert to a Roth IRA Tax-Free

If you’ve experienced a financial loss in a given year, you might have heard of something called a Net Operating Loss (NOL). While NOLs can feel like a burden, they can be a valuable tool, especially when it comes to converting funds from a Traditional IRA to a Roth IRA. In fact, with careful planning, you could use an NOL to convert funds to a Roth IRA without paying taxes on the conversion!

Let’s break it down in simple terms, so you can see how this strategy works.

What is a Net Operating Loss (NOL)?

A Net Operating Loss (NOL) occurs when your deductible expenses exceed your income for a given tax year. Essentially, you have more losses than gains. This can happen if you run a business at a loss, have high medical expenses, or experienced a major loss from a qualified disaster. (Hurricane Milton and Helene were both qualified disasters) The key thing to remember is that an NOL means your taxable income is negative for the year.

But don’t worry—this isn’t all bad! Having an NOL means you can carry that loss forward to offset future taxable income, or used to create a tax free Roth bucket.

How Does a Roth IRA Conversion Work?

A Roth IRA conversion is when you transfer funds from a Traditional IRA or another tax-deferred retirement account to a Roth IRA. When you do this, you pay taxes on the amount you convert because Roth IRAs are funded with after-tax money (meaning future withdrawals are tax-free).

However, the good news is that you don’t pay taxes on the amount you convert until you actually make the conversion. This is where your NOL can play a big role in reducing or eliminating the taxes you would owe on a Roth IRA conversion.

How Can an NOL Help with Roth Conversions?

Here’s the key: If you have an NOL in the same year as your Roth IRA conversion, the loss can reduce the amount of taxable income for that year, which could eliminate or greatly reduce the taxes owed on the conversion.

Here’s an example:

• Let’s say you have $30,000 in a Traditional IRA, and you decide to convert all of it to a Roth IRA.
• Normally, this $30,000 would count as taxable income, meaning you’d owe taxes on it.
• But what if you also have an NOL of $30,000 that year? The NOL can offset the $30,000 of taxable income from your Roth IRA conversion, meaning you don’t owe any taxes on the conversion!

In essence, the NOL “cancels out” the taxable income from the Roth conversion, making it tax-free.

How Does the NOL Work with Roth Conversions?

• Timing is Key: If you’re doing a Roth IRA conversion in a year when you have an NOL, you can use the NOL to reduce your taxable income for that year. This is especially useful if you have a significant loss and a Roth conversion on the horizon.
• Excess NOLs: If your NOL is larger than the amount you’re converting, that’s okay! You can carry the excess NOL forward to future years to offset other taxable income. In other words, if your NOL is more than enough to offset the conversion, the leftover NOL can be used in future years to reduce taxes on other income (including any future Roth conversions).
• Planning for Future Conversions: If you’re planning to do a Roth IRA conversion over several years, using NOLs strategically could help you minimize taxes on each conversion. For example, if you experience a large loss one year, you might convert more funds from your Traditional IRA to a Roth IRA in that year, using the NOL to offset the tax impact.

What If You Don’t Have a Large NOL?

Even if you don’t have a massive NOL, but you do have some form of loss (like from business operations, investments, or casualty losses), it can still be useful. A smaller NOL can help reduce some of the taxable income from a Roth conversion, making the tax burden much more manageable.

Other Things to Keep in Mind

1. Carryforward of NOL: For tax years after 2020, the IRS allows NOLs to be carried forward indefinitely, meaning you can use your NOL to offset income in future years, including any Roth conversions.
2. NOL Deduction Cap: Taxpayers are allowed to deduct up to 80% of taxable income per year.
3. Roth IRA Benefits: One of the main benefits of a Roth IRA is that future withdrawals are tax-free, so the upfront tax savings from using an NOL can lead to long-term tax benefits. Roth IRAs can be a great retirement tool for this reason.
4. Tax Planning: Roth conversions can be an effective way to reduce taxes in the future, and pairing them with an NOL can make it a powerful strategy. Be sure to consider your long-term tax situation when deciding how much to convert.

Conclusion: How to Use an NOL for a Tax-Free Roth Conversion

If you have a Net Operating Loss (NOL) in the same year as a Roth IRA conversion, you can potentially convert your IRA to a Roth IRA tax-free. By using the NOL to offset the taxable income from the conversion, you can avoid paying taxes on the amount you convert, which can be a major advantage for your retirement savings. At Decima Wealth Consulting, we do detailed reviews of your tax form, to create an optimal conversion strategy for your situation.

But as with any tax strategy, it’s important to plan carefully. If you’re unsure about how to use an NOL to its full potential, or if you want help with Roth conversions, it’s always a good idea to consult with a tax professional. They can guide you through the best ways to take advantage of NOLs and help you make the most of your Roth IRA strategy. See more about IRS publication 536 here.