Last year, we wrote a blog article about Roth Conversions. This article went into depth on what they are, how they could be beneficial for your retirement or estate plan, and other things to consider. You can read more about these items by visiting the below link:
Roth Conversions: Do they enhance your financial plan? (finplans.com)
As we head into the fourth quarter of the year, it is important to start considering whether a Roth Conversion is right for you. By converting a portion of your IRA to your Roth IRA, you will be adding this amount to your taxable income for the year. However, all future growth of the amount that you convert will be tax-free if you meet the five-year holding period requirement before taking a distribution on the amount you convert. 1
If you know a Roth Conversion makes sense for you, it is important to consider how you will pay the taxes. You can withhold taxes on Roth Conversions and send a portion of your conversion to the IRS and State. However, this will increase your taxable income and dilute the amount of money you are wanting to move to your Roth IRA.
For example: You choose to convert $10,000 from your IRA to your Roth IRA in 2021. Since you are moving these funds from a tax-deferred account in your IRA to an after-tax account in your Roth IRA in this scenario, you will add $10,000 to your gross income for the year. If you choose to have the taxes withheld from your conversion and send $1,500 of the conversion to the IRS and $500 to the state, then at the end of the day you have only moved $8,000 to your Roth IRA. You have increased your taxable income by $2,000 for the year to pay taxes.
While withholding taxes from your Roth IRA is a convenient way to pay the tax bill, we recommend trying to find an alternate funding source if possible. If you have money in savings or a taxable investment account, you can use these funds to pay the bill. Taxable investment accounts include Individual accounts, TODs, Joint Investment accounts and Trust accounts. When you take a distribution from these types of accounts, you are paying the taxes based off the growth of your investments.
For Example: In your TOD investment account, you have a current balance $40,000. Of this, your initial contribution was $30,000 and you have $10,000 of growth. Because you have held these funds for over 1 year, you will pay long-term capital gains taxes on the growth. For most individuals the capital gains rate is 15%. 2 When you liquidate your TOD investment account, you will pay 15% on the $10,000 of growth or a total $1,500 in taxes. If you were to take $40,000 out of your IRA, then you would add $40,000 to your ordinary income and pay this based off the ordinary income tax rates which tend to be higher for most individuals. 3
Roth Conversions can be very beneficial, but it is important to plan for the taxable impact that these conversions produce. Please call our office to speak with your advisors if you have questions or if we can help you complete a Roth Conversion. Please remember, the Roth IRA Conversion deadline is December 31st!