By Andy Ives, CFP®, AIF®
The King of the Land wanted to send 100,000 of his greatest warriors off to battle. However, he was told that 20,000 of the warriors needed to remain behind to protect the castle. The King of the Land did not like this news. He wanted a full complement of soldiers in the fight. So, the King of the Land decided to send all 100,000 warriors off to battle, and he used an additional 20,000 warriors from another army to protect the castle.
The investor wanted to convert $200,000 of his traditional IRA to a Roth IRA. However, it was recommended that he withhold 24% for taxes. The investor did not want to send only $152,000 to his Roth. The investor wanted all $200,000 growing tax-free. So, the investor had 0% withheld, converted the full $200,000, and used $48,000 from a non-qualified savings account to pay the taxes due.
Roth conversions are a taxable event that add to ordinary income for the year of the conversion. While the tax is not due immediately upon conversion, it will be owed at tax time. To get ahead of a potentially large tax hit, one can have a certain amount withheld at the time of the conversion (i.e., sent to the IRS). Any amount can be withheld for taxes, and the choice is yours.
The drawback is that withheld taxes that could otherwise be moved to the Roth IRA get sent to the government. For some, withholding is their only option. They may not have another source of funds to pay the taxes. They have no other army to protect their castle. But for those that do have other means, it is suggested they be leveraged. This is especially true for anyone doing a Roth conversion under the age of 59 ½ for the reasons outlined here:
Example: Jonathan is 45 years old and handles all his financial affairs on-line with no professional guidance. After logging into his account, he converts $50,000 to a Roth IRA and elects to have 20% withheld for taxes. Jonathan’s conversion results in only $40,000 going to the Roth ($50,000 x 80% = $40,000). The 20% withheld for taxes ($10,000) never actually gets converted and is, technically, a withdrawal prior to the conversion. Since Jonathan is under 59 ½ and no other exception applies, there is a 10% early withdrawal penalty ($1,000) on the money that was sent to the IRS. In addition, the $50,000 counts as ordinary income for the year, which pushes Jonathan above the income threshold for the financial aid he was receiving for his daughter’s college education.
Be careful before diving headfirst into a Roth conversion. Evaluate your income for the year and determine how much wiggle room you have before potentially pushing into the next tax bracket. Remember that Roth conversions can impact financial aid, IRMAA surcharges and other items based on income. While tax-free earnings in a Roth are a great motivator, also understand that using IRA funds to pay taxes on a conversion will reduce the conversion amount, thereby potentially setting your retirement account back.
Not everyone has extra cash in a non-qualified account available to cover the taxes on a Roth conversion. For that reason alone, it is imperative to do your homework. Consult with a financial professional. Understand the math and if a Roth conversion makes sense for you. Be the King of Your Land and protect your financial castle.