Tax planning and compliance for investors
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Kaye A. Thomas
Updated September 25, 2006
Think carefully about where the money will come from to pay tax on converting a traditional IRA to a Roth IRA.
If you convert your traditional IRA to a Roth IRA you'll have to report some income and pay tax. How you pay that tax is a key question in determining whether you'll benefit from the conversion. On another page we discuss How Much Conversion Tax you'll have to pay. This page explains why the source of funds for paying the tax affects your decision on whether to convert.
How will you pay the tax on converting your IRA? The best answer is, "From my regular savings or brokerage account." Here's why.
The greatest long-term advantage of the Roth IRA comes from the fact that it is effectively larger than a traditional IRA. That's a hidden benefit, because the number of dollars in the Roth IRA is the same as the number of dollars in a traditional IRA. But the dollars in the Roth IRA are after-tax dollars, which means you get to keep all those dollars when you take them out. In a traditional IRA, your withdrawals are taxable. You don't get to keep all of the money you withdraw, and that means a traditional IRA is effectively smaller than a Roth IRA, even when the dollar amount in each is the same. For more discussion, see The Roth IRA Is Bigger.
Ability to pay the conversion tax from funds other than your IRA is one of the key indications that conversion is a good choice.
There may be situations where your only source of funds outside the IRA is very expensive. For example, you may have to sell a highly appreciated asset and pay a significant amount of capital gains tax. If that is the case, and you otherwise would have avoided reporting that capital gain for a significant period of time, you should consider this additional cost when you weigh the decision to convert your IRA.
Many people have savings in IRAs and not much in the way of other savings. If you are in this situation, you may find that the only available source of funds to pay the conversion tax is the IRA itself.
If you're under age 59½, you'll probably have to pay a 10% penalty on any portion of the IRA you use to pay tax on the conversion. There's no exception to the penalty tax for amounts used for this purpose. You may find that you can fit into one of the other exceptions to the 10% early distribution penalty, but that would be a coincidence.
In this situation, you have two strikes against you. The first strike is that you're not taking advantage of one of the most important benefits of a Roth IRA conversion: the ability to have an IRA that's effectively bigger. The ideal situation is to end up with the same number of dollars in a Roth IRA (where they are after-tax dollars) as you had in your traditional IRA (where they are pre-tax dollars). If you use part of your IRA to pay tax on the conversion, you're not accomplishing that goal.
The other strike against you is the penalty itself. Stacking an extra 10% on top of the regular conversion tax makes for a heavy load. It will rarely be the case that the benefits of a Roth IRA conversion will overcome this detriment, especially when one of the key benefits, the ability to have a larger IRA, has been removed.
There's one situation where it may make sense to convert even though you'll pay the early distribution penalty on amounts used to pay the tax. Some people have traditional IRAs that consist mostly of nondeductible contributions. Perhaps you weren't able to deduct your contributions because you participated in a retirement plan sponsored by your employer and were above the income threshold. In this situation, even though you're paying a 10% penalty on the taxable portion of the amount you use to pay the conversion tax, the overall benefit of the conversion can outweigh the penalty because the tax, and the penalty, apply to only a small fraction of the total amount in the IRA.
If you expect to use money from the account to pay the tax, it's better to hold that money out from the conversion rather than convert the full amount and pull the tax money from the Roth IRA — unless you have other money in the Roth IRA you can withdraw free of tax and penalty.
If you're over age 59½, you can use IRA money to pay the conversion tax without incurring a 10% penalty. In this situation you've lost the ability to increase the size of your IRA, but you don't have the added burden of paying the penalty tax. A Roth IRA conversion can still pay off in this situation, but you have to be looking for a benefit other than the increased size.
One possible benefit would be avoiding the minimum distribution rules that apply to traditional IRAs when you reach age 70½. If you anticipate having financial resources to live without taking the full amount of the required minimum distributions, a Roth IRA conversion may provide a significant benefit. Avoiding minimum distributions after age 70½ is another way of increasing the size of your IRA. If you the amount you withdraw during at least some of these years, you'll have a larger account to use in your later years or to leave to your children or other beneficiaries.
Another possible benefit would be to reduce estate tax. Converting to a Roth IRA means "prepaying" the income tax on the IRA. That prepaid income tax reduces the size of your estate, and as a result reduces the amount of estate tax when you die. Before doing a Roth IRA conversion for this purpose, you should consult your estate planning professional to determine whether this possible benefit will fit into your estate plan. For more discussion see Post-Retirement Conversion.
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