If you have business owner clients that you believe could benefit from a Roth IRA conversion, a good first step may be to inquire about net operating losses (NOL). The income generated by a Roth IRA conversion may be offset by the NOL, and the business owner may not incur any additional tax liability. Additionally, there is no limit to the amount of income that can be offset by a NOL.

Consider a sole proprietor who has a SEP IRA (a traditional IRA for self-employed individuals) worth $200,000, and whose business experienced losses totaling $150,000 in a given year. His spouse’s annual income was $75,000. The couple also reported $5,000 in income from interest and dividends, bringing their total income to $80,000.

The loss is greater than the income, for a NOL of $70,000.

In this case, the couple may decide to convert $70,000 from the SEP IRA and use it to offset the loss, and possibly avoid generating any tax consequences.

INCOME
Spouse’s wages $75,000
Interest and dividends 5,000
Total income 80,000
DEDUCTIONS
Net business losses
(itemized deduction and personal exemptions
not allowed in net operating calculation)
(150,000)
NOL for tax year (70,000)
Income from Roth IRA conversion 70,000
Net taxable income 0

Example is for illustrative purposes only.

The strategy of using the Roth conversion to offset a NOL can be even more beneficial in a future year if the investor believes he or she will be in a higher tax bracket.

These calculations can be complex, and investors should consult with a tax professional or financial advisor to decide what is the best strategy for reporting a loss.

Net operating loss can generally be applied against prior two tax years. In some cases, taxpayers may be able to carry back a net operating loss for up to two years. Consult a qualified tax professional for more information, or refer to IRS publication 536: “NOLs for Individuals, Estates, and Trusts”

Current tax laws are subject to change.