When implementing your Roth conversion strategy, you may want to decide how to pay tax on your conversion. You can either pay taxes from converted amount, or convert the full amount and pay with outside money.
Roth conversions in tax planning
Roth conversions can be an important tax planning tool.
When evaluating your retirement assets, you should consider how the value of your investments will grow over time. Tax-deductible (and tax-deferred) investments will eventually come out of your accounts in retirement age, increasing your future gross income.
Let’s be clear: you do pay taxes on conversions to a Roth IRA. But even if you increase your taxable income with Roth conversions today, you’ll be able to take advantage of those tax-free withdrawals down the road. And if you convert everything to a Roth account, you can also avoid required minimum distributions (RMDs).
In the long run, your tax situation might be better, and you can keep more of your tax dollars in your retirement savings.
The flip side is this: if you guess wrong, you might get pushed into a higher tax bracket, paying higher tax rates. So consult with your tax advisor before implementing your Roth conversion strategy.
Proper tax planning will help you optimize your current tax rate without significantly impacting your future tax rate.
When you might start thinking about tax payments
How much do you want to withhold in taxes?
Most financial advisors offer the option for clients to select how much money in terms of percentages. Once the selection is made, your financial institution will send the appropriate amount to the IRS.
At the end of the tax year, you’ll receive a Form 1099-R. Block 4 of the Form 1099-R will indicate how much was withheld for federal taxes.
Ways to pay
Having a discussion with your advisor presents 2 (or really more) ways to consider how to pay the additional taxes on your Roth conversions:
- Select an appropriate percentage withheld in estimated taxes. This amount would correspond with your marginal tax bracket.
- Withhold no estimated taxes for your Roth conversions, and pay the taxes with outside money when you file your tax return.
There is also a third option, which is to find some sort of middle ground. You could select some withholding for estimated taxes, but at a lower tax rate.
You would make up the difference by either making estimated tax payments later, or when you file your tax return. This might work if you want to make some payments from your conversion, but you want to put as much into your Roth IRA as possible.
This article will help illuminate the differences in these two approaches, and discuss why you may want to be deliberate when selecting what is appropriate for you.
Note: This article only discusses federal income tax withholding. If you are a reader who lives in a state that charges income tax, you may have to do a little extra work to account for state taxes.
At the very least, you should have the discussion with your investment advisor or tax professional so they can do the work for you.
Roth conversion option one: Pay as you go from your Roth conversion
For many people, this is a default option. A professional advisor, such as a Certified Financial PlannerTM can run a tax projection to illustrate the tax consequences of your conversion. If the tax projection is done properly, there should be little impact on the amount of income taxes owed (or refunded) at tax time.
Calculate how much to withhold based on your marginal tax bracket
From there, it’s as simple as calculating the amount being withheld. The most straightforward way to calculate this is by tying the withholding to your marginal tax rate.
For example, let’s imagine that you want to do a $30,000 Roth conversion. You are in the 22% tax bracket.
When entering the transaction, simply withhold 22% from the Roth conversion, or $6,600. Investment advisors can do this for you. This allows your financial institution to:
- Withdraw $30,000 from your traditional IRA
- Withhold $6,600, which is then remitted to the IRS as a tax payment
- Transfer $23,400 into your Roth IRA.
Many people appreciate being able to do Roth conversions without much impact to their cash flow. However, the trade-off is that less money makes it into the Roth account.
Remember, your ability to make traditional or Roth IRA contributions, is limited. The above example essentially removed about a year’s traditional IRA contribution from the account balance.
With that in mind, this might not the most tax-efficient option. In essence, you’re trading tax-efficiency for cash flow convenience.
To avoid this, you can look at option two.
Roth conversion option two: Pay taxes with outside money
For people who are more concerned about tax efficiency than cash flow, this might be the better option.
Using the above example, you would simply select 0% withholding when transferring from your IRA. This would ensure that 100% of the $30,000 IRA withdrawal lands in the Roth account.
Of course, this assumes that the $6,600 in additional taxes is paid in some other fashion. This doesn’t mean that you have to have $6,600 sitting in a bank account for the sole purpose of paying your tax bill.
Below are a couple of ideas worth considering:
Does your tax projection show you on track for having a refund?
If your tax projection shows a huge refund, good news! You may be able to do a Roth conversion with little or no discernible impact to your cash flow.
Increase tax withholdings in your paycheck
If cash flow isn’t an issue, you could increase the taxes withheld from your paycheck. While the increased tax withholdings might not seem like investing per se, it’s a way to pay tax money throughout the year. That way, you don’t get hit with a big tax bill when filing your return.
Use a maturing bond or CD
If you have a bond or CD ladder, you might have something maturing soon. Many retired people use bond ladders to help stabilize their cash flow. Since you don’t pay taxes on a maturing bond or CD (other than taxable interest), this might be a good option.
Harvest some capital losses
If your advisor is making investment recommendations, we always point out the additional tax from that sale. While taxes shouldn’t drive your investment philosophy, you should factor capital losses (or tax-loss harvesting) into your trades. Capital losses can lower the tax liability on ordinary income by up to $3,000 per year.
Capital gain harvesting
While the previous approach is known as tax-loss harvesting, this is tax-gain harvesting. It is particularly attractive for someone in the 12% marginal tax bracket (where the tax rate on long term capital gains is 0%).
A smart advisor might recommend the following for clients:
Run a tax projection for the current year
This is to ensure the client is projected to remain within the 12% tax bracket. The projection should include an estimate of how much of a capital gain they can still take while remaining in the 12% tax bracket.
Sell an appreciated investment to generate a capital gain
Ensure the client remains within the desired tax bracket.
Repurchase that same investment
Or a different one if your portfolio needs rebalancing.
Since this is a taxable gain, there is no wash sale rule
The tax law states that for capital losses, you have to wait 31 days in between selling one investment and repurchasing it or a substantially similar security. Otherwise, you cannot deduct the loss on your tax return.
You might not need to generate any outside cash
If that’s the case, then it might make sense to keep as much of your investments inside your Roth accounts as possible, and pay your taxes with outside cash.
Regardless of how you generate this cash, you’ll want to ensure that you are having enough money remitted to the IRS throughout the year to avoid underwithholding penalties. Most people do this in one of two ways:
- Having taxes withheld from their paychecks or IRA withdrawals, or
- Sending estimated taxes directly to the IRS periodically throughout the year.
Usually, your tax professional can help you calculate estimated taxes. Many of them automatically do this by generating estimated tax payment vouchers (using Form 1040-ES) when they prepare your previous year’s tax return. If you don’t see estimated tax vouchers with your previous year’s tax return, ask your tax advsior.
Backdoor Roth conversions
Backdoor Roth IRA conversions are usually for higher-income taxpayers whose tax filing status will not let them contribute directly to a Roth account. Here are the basic steps of a backdoor Roth conversion:
- Make a non-deductible contribution to your traditional IRA.
- Once the money is in your traditional IRA, you can convert it directly to a Roth account.
Fortunately, you do not have to pay taxes on non-deductible contributions when you do a backdoor Roth conversion. However, there are IRS rules that you need to keep in mind. For specific situations, you’ll want to seek tax advice before doing this yourself.
There is no right way or wrong way to pay your taxes when doing Roth conversions. Paying taxes from the IRA withdrawal allows you to do conversions while minimizing impact to your cash flow. If cash flow is not a problem, then paying your taxes with outside money allows you to maximize the amount of money that ends up in your Roth account.
Of course, there are any number of ‘in-between’ options for people who might not be committed to either extreme. In any case, Roth conversions shouldn’t be done in a vacuum.
They should be done as part of a deliberate Roth conversion strategy, either one that you’ve created on your own or that you’ve created in consultation with your tax professional or investment advisor.