When discussing a possible Roth IRA conversion with clients, typically the primary barrier is identifying funds to pay the tax bill. Clients understand the benefits that a tax–free Roth can provide in retirement and to potential heirs, but are challenged by reporting additional income generated from a conversion. Using business–related tax losses to offset a Roth IRA conversion is a strategy that may help to lessen the tax bite caused by a conversion.
Clients or prospects who may benefit from this strategy are small business owners as they may have tax losses associated with operating their business.
What are net operating losses?
A tax loss associated with operating a business is a net operating loss (NOL). The Internal Revenue Service provides more detail about the definition of NOLs in its publication 536, Net Operating Losses for Individuals, Estates and Trusts. The business must be considered a “flow-through” entity for tax purposes, meaning that any business income, or losses, is carried over to the personal income tax return. These types of businesses include sole proprietors, limited partnerships, and S corporations.
Using an NOL
There are two options for applying an NOL against other income. A taxpayer can elect to apply the loss against previous tax returns, for a maximum of five years in some cases and a minimum of two years, which is referred to as a “carryback.” Or, a taxpayer can elect to apply the NOL against future tax years, for a maximum of 20 years, which is referred to as an NOL carryforward. Unlike net capital losses where taxpayers are limited to using only $3,000 annually to offset any ordinary income, there is no limit on how much of an NOL can be used to offset ordinary income. For clients carrying forward large NOLs, adding additional income from a Roth IRA conversion may make sense. This can result in very large conversions without any tax consequences.
Example: Using an NOL to offset income from a Roth IRA conversion.
The below illustration makes the following assumptions:
- John is a sole proprietor, married with two children
- He has a SEP IRA valued at $200,000
- Due to investments within the business and a poor economic environment, business losses total $150,000
- His wife earns $75,000 annually
- They report an additional $5,000 in income from interest and dividends
- Non–business deductions total $35,000 (itemized deduction + personal exemptions)
- End result: John is able to convert $70,000 of his SEP IRA to a Roth without tax consequences
|Interest and dividends||5,000|
|Net business losses (itemized deduction and personal deductions not allowed in NOL calculation)||(150,000)|
|NOL for tax year||(150,000)|
|Net business losses (itemized deduction and personal deductions not allowed in NOL calculation)||(70,000)|
|Income from Roth IRA conversion||70,000|
|Net taxable income||0|
Local partnerships can provide valuable benefits
Rules around calculating and utilizing NOLs are complicated, so it is critical for clients to consult with a qualified tax professional. This presents an excellent opportunity for financial advisors to form strategic relationships with local CPAs who can assist business–owner clients and potentially provide valuable referrals for IRA and other investment business.
Download our investor education piece, Converting a Traditional IRA to a Roth IRA for more information.