Roth Conversions
Whenever you make contributions into a Traditional IRA, or into an Employer-Sponsored Defined Benefit Plan (i.e., 401(k) plan, 403(b) plan, etc.), the amounts of the contributions are deducted from the taxable compensation that you receive. These contributions are known as “pretax” contributions. Any income taxes due on these pretax contributions will be deferred until you begin to take distributions from your Plan once you’ve reached retirement age. The presumption is that, once you reach retirement age, you will transition into a lower Federal income tax bracket.
The deferral of any income taxes due on the retirement contributions made is a timing issue. You opt to pay those income taxes at some future time rather than pay them when you receive the income.
In making a Roth Conversion, you opt to pay the income taxes due on amount being converted now. Why? Because you would like the converted Roth IRA funds to capitalize on The Power of Compounding and grow tax-free for the rest of your lifetime. That’s a very compelling argument for considering such a conversion. The drawback to making a Roth Conversion: you will incur significant federal and state income tax liabilities that you must pay in the year that the conversion takes place.
Tax Tip
Pay any Federal and state income tax liabilities that you incur by making Estimated Tax Payments in the quarter that you made the conversion. This will help to minimize or perhaps even eliminate any penalties and/or interest that may be assessed on your return when it is e-filed the following April.
In general, there are two sets of circumstances in which making a Roth Conversion would make good financial sense:
- During a down economy. Your overall taxable income is likely to be lower, which would put you into a lower federal income tax bracket.
- You’ve had a particularly good year financially. You have the funds readily available to pay whatever income tax liabilities may be incurred because of the conversion. And you want to capitalize on The Power of Compounding and grow these funds tax-free for the rest of your lifetime.
Tax Tip
Whenever possible, utilize funds that you have available from sources other than the retirement funds to be converted to pay the Federal and State income tax liabilities incurred by the Roth Conversion. This will allow the converted Roth IRA funds capitalize on The Power of Compounding and grow tax-free for the rest of your lifetime.
Let’s take a look at an example to understand why this approach is such a good idea.
Suppose that you plan to convert $100,000 from a Traditional IRA into a Roth IRA. Your Federal Effective Tax Rate (ETR) is 15%, so your federal income tax liability would be $15,000.
New Hampshire Residents
If you pay your Federal income tax liability out of the retirement funds to be converted, your new Roth IRA account will have a beginning balance of $85,000.
- Let’s assume an investment rate of return of 5.0% APR, compounded monthly.
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It will take 4 years and 4 months for your converted Roth IRA account balance to compound and grow back over the original $100,000 amount converted, to $100,381.
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Instead, if you had paid your Federal income tax liability with funds from other sources, your new Roth IRA account will have a beginning balance of $100,000. During that same 4 years and 4 months’ time frame, your converted Roth IRA account balance would have compounded and grown to $118,095 – a difference of $17,714.
| -------- | Difference between income tax payment approaches | $ | 17,714 | -------- | |
| Federal income tax you paid | (15,000 | ) | |||
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| Net increase to you | $ | 2,714 | +18.10% |
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- Now let’s assume an investment rate of return of 8.0% APR, compounded monthly.
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It will take 3 years and 1 month for your converted Roth IRA account balance to compound and grow back over the original $100,000 amount converted, to $100,360.
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Instead, if you had paid your Federal income tax liability with funds from other sources, your new Roth IRA account will have a beginning balance of $100,000. During that same 3 years and 1 month time frame, your converted Roth IRA account balance would have compounded and grown to $118,071 – a difference of $17,711.
| -------- | Difference between income tax payment approaches | $ | 17,711 | -------- | |
| Federal income tax you paid | (15,000 | ) | |||
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|
|||||
| Net increase to you | $ | 2,711 | +18.07% |
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Massachusetts Residents
In addition to your Federal income tax liability of $15,000., your Massachusetts income tax liability would be 5.0% or $5,000. If you pay your Federal and Massachusetts income tax liabilities with funds from the retirement funds to be converted, your new Roth IRA account will have a beginning balance of $80,000.
- Let’s assume an investment rate of return of 5.0% APR, compounded monthly.
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It will take 5 years and 6 months for your converted Roth IRA account balance to compound and grow back over the original $100,000 amount converted, to $100,139.
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Instead, if you had paid your Federal income tax liability with funds from other sources, your new Roth IRA account will have a beginning balance of $100,000. During that same 5 years and 6 months’ time frame, your converted Roth IRA account balance would have compounded and grown to $125,174 – a difference of $25,035.
| -------- | Difference between income tax payment approaches | $ | 25,035 | -------- | |
| Federal and Massachusetts income taxes you paid | (20,000 | ) | |||
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| Net increase to you | $ | 5,035 | +25.17% |
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- Now let’s assume an investment rate of return of 8.0% APR, compounded monthly.
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It will take 3 years and 10 months for your converted Roth IRA account balance to compound and grow back over the original $100,000 amount converted, to $100,277.
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Instead, if you had paid your Federal income tax liability with funds from other sources, your new Roth IRA account will have a beginning balance of $100,000. During that same 3 years and 10 months’ time frame, your converted Roth IRA account balance would have compounded and grown to $125,347 – a difference of $25,069.
| -------- | Difference between income tax payment approaches | $ | 25,069 | -------- | |
| Federal and Massachusetts income taxes you paid | (20,000 | ) | |||
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| Net increase to you | $ | 5,069 | +25.35% |
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Tax Tip
Start Making Your Roth Conversions Early!
Don’t wait until you turn age 72 to begin converting funds from your Traditional IRAs or Employer-Sponsored Defined Benefit Plans (i.e., 401(k) plans, 403(b) plans, etc.) into Roth IRAs. You can start converting your pretax retirement plan funds into Roth IRAs as soon as you reach age 59½.
There are several very good reasons to begin making your Roth IRA conversions early:
- To capitalize on The Power of Compounding to grow your Roth IRA account balances tax-free for the rest of your lifetime.
- By starting earlier, you will have more time (as in years) to make such conversions, as well as the option to convert smaller amounts, say $10,000 or $25,000 a year, into Roth IRAs. This will help to lessen the resultant income tax liabilities incurred each year.
- It will be easier for you to pay the resultant income tax liabilities while you are still working.
Tax Tip
Avoiding Early Withdrawal Penalties
If you make a Roth conversion, you must wait five years or until you reach age 59 1/2 before you can withdraw the converted amount free from the IRS’ 10% early withdrawal penalty. The clock for those five years starts on January 1 of the year that you make the conversion. You could make the conversion late in a year, meaning you would have to wait closer to four years before you can touch earnings without penalty.
Each conversion has its own five-year holding period. If an individual does one conversion in 2024 and a second conversion in 2025, the amount from the first conversion can be withdrawn penalty-free starting in 2029 and the amount from the second starting in 2030.
Earnings on a converted amount can be withdrawn tax- and penalty-free after the owner reaches age 59 1/2, as long as he or she has had any Roth IRA opened at least five years.
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