Conversions to Roth accounts can be a great tax-savings move, but conversions cost money. Choosing to use nonretirement funds to pay the taxes is the way to go. Ill explain.
Q. Hi Dan, In a question about Roth conversions when your income changes you wrote, "…if you don’t have money outside of your IRAs to pay the tax on the conversion, you undermine the math…" Why is that?
A. Paul, when space allows, I try to mention the math whenever I answer questions about conversions to Roth accounts because the difference between paying the taxes on a conversion with retirement account dollars and paying from other accounts is easy to miss. The bottom line though is this; which is better
1. $50,000 that can grow in an account that will never be taxed or
2. $50,000 spread between a never to be taxed account and an account subject to taxation every year?
Obviously No. 1 is better. The more that is converted , the higher the tax brackets that apply to No. 2, and the more years, the bigger the difference becomes.
Say you have $50,000 in a traditional IRA and it compounds at 6% annually for the next 10 years. That’s $89,542 of yet-to-be-taxed money.
If you convert the $50,000 IRA to a Roth IRA, assuming a 15% tax bracket, taxes due would be $7,500 ($50,000 X 0.15). If you pay those taxes with nonretirement account funds and the Roth assets also earn 6%, you’ll have $89,542 of never-to-be-taxed money in the Roth IRA in a decade.
Now, if you pay the taxes with money from the original IRA, only $42,500 ends up in the Roth and you still have $7,500 in an outside account. So the day after the conversion, the comparison is $50,000 in a never-to-be-taxed account (the Roth IRA) vs $42,500 in the Roth IRA and $7,500 in an account subject to taxation.
After 10 years at 6%, that $42,500 in the Roth is only up to $76,111. To get back to a total of $89,542, the $ 7,500 in the outside account must grow at 6% after all taxes due on that account over the 10 years.
In addition, you have to remember that you shouldn’t convert in the first place unless your tax rate is expected to be higher in the future. In such a scenario, beating the after-tax growth target could get even more difficult due to higher tax rates.
If you do not have any money outside of retirement accounts to pay the taxes, paying from the IRA may require future tax rates to be even higher depending on your age. Because the funds withheld to pay taxes do not go into the Roth account, they are treated as a distribution rather than a conversion. If you are under 59 陆, you’ll owe a 10% penalty on the taxes paid that must be overcome.
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Dan Moisand ‘s comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.