The Roth Retirement Account is a powerful savings tool that provides investors with improved tax efficiency, the potential for tax-free growth, increased legacy options, and flexible financial planning strategies. With such a diverse array of benefits, it’s understandable that many Americans would want to convert their existing pre-tax Traditional retirement account funds into post-tax Roth funds. However, one aspect is often overlooked when executing a Roth conversion – how are you going to pay for the taxes?
You typically fund a Roth account with funds you’ve already paid taxes on. For example, you receive payment for labor and services, set aside funds for taxes (or perhaps your employer withholds a portion for taxes), and from the remaining amount, contribute to your Roth. This is in stark contrast to a Traditional contribution, which sees you deferring your tax payment until you withdraw your contributions and earnings in retirement. The benefit of the Traditional IRA is that you will pay fewer taxes that year.
However, another way to fund a Roth is to convert your pre-tax Traditional funds to Roth funds by paying your fair share of taxes on both the contributions and earnings and moving your assets over to a Roth account. This is where things get complicated, as many factors come into play. One of the most significant factors is figuring out how to pay the taxes you’ll owe on any converted funds. By the way, you’ll be paying tax on both the contributions and the earnings, and the extra income may even bump you up a tax bracket, completely altering your tax strategy for the year if you fail to account for it.
Let’s look at a few ways to pay that substantial tax bill.
Let’s say you know you’ll owe $10,000 in taxes if you execute your conversion. In many cases, if you have the cash on hand, it’s optimal to simply pay that bill with those funds. However, you may want to ask yourself the following questions. Will you place yourself in a risk zone if you use those funds? How would you use those funds if they weren’t sitting in your account? And how much money could you make by simply investing that $10,000? If the answer is more than you would gain by converting over the long run, maybe it’s not the right time for a conversion.
If you don’t have the cash on hand to pay your tax bill before touching your retirement accounts, you may want to sell stocks or bonds in your brokerage account. However, you need to pay close attention to the tax burden you will incur. If you sell assets you’ve had for longer than a year, you’ll be taxed at the lower long-term capital gains rate, and it won’t affect your ordinary taxable income, meaning it won’t push you up a tax bracket.
However, if you sell any stocks or bonds that you’ve had for less than a year and you’ve earned money on those assets, you’ll be taxed at the lower short-term capital gains rate, which does get pooled together with your ordinary taxable income.
This option is often considered the least favorable. Not only will you pay taxes on the conversion itself, but you’ll also incur taxes on the withdrawal used to pay those conversion taxes. If you use newly created Roth funds, you’re setting yourself back too. Additionally, if you’re under the age of 59½, you may face a 10% penalty.
So, you’ve decided to convert and figured out how to pay that tax bill. You wait until April of the following year to pay it, just to discover your tax bill is significantly more substantial than you expected. What went wrong?
If you convert from a traditional IRA to a Roth IRA early in the year, your quarterly income—and consequently, your quarterly taxes—will rise. For example, if you convert during the first quarter, the tax resulting from that conversion would be due by mid-April (Tax Day). Delaying this payment until the year’s end or when you file your taxes could lead to additional penalties and interest, turning what might be a strategic financial move into a costly error.
Once your funds are in the Roth account, you can’t touch them for five years without getting penalized. Also, if you used retirement funds to pay your tax bill, you should wait until your funds have caught up to pre-conversion levels, if possible. A financial advisor can conduct a break-even analysis to estimate when your funds will catch up to pre-conversion levels.
If so, consider staggering your conversions over a few years until you convert the desired amount.
If you pay your tax bill by selling assets, converting during market highs will make it more difficult to catch back up. Consider selling during a market downturn instead. Plus, tax loss harvesting can help cover the tax bill if you sell assets at a loss.
Navigating the complexities of a Roth conversion can be both rewarding and daunting. While the promise of tax-free growth and increased financial flexibility is enticing, the maze of tax implications and financial considerations can’t be ignored.
As seasoned dual CPAs and financial advisors, we can help you weigh the pros and cons of a Roth conversion, assist you in determining the most tax-efficient method of funding it, and create a comprehensive plan tailored to your financial goals and lifestyle.
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