Think Twice Before Doing a Roth IRA Conversion if You Are Using Account Assets to Pay the Taxes Due

Using Roth Assets to Pay Tax Liability May Eliminate Conversion Benefits

Everyone loves the Roth IRA. If you read any personal finance blog, website, or listen to any financial guru they will rave about how the Roth IRA is the best thing since sliced bread. What makes this investment vehicle even better is that starting in 2010 anyone can convert their Traditional IRA (therefore pre-taxed) accounts to a Roth IRA regardless of their income. Wow, the government is really doing investors a a favor, aren’t they? Now even those who were not eligible for a Roth IRA in the past can now convert all of their money so that it’s tax free in retirement!

Not so fast. While it’s generally accepted that the Roth is going to be a better option for a lot of people in retirement you can’t discount the true cost of the conversion. In most cases, the argument is that many people will be in a lower tax bracket right now and at the time of the conversion compared to in retirement. This has to do with the fact that the government has a nasty habit of increasing taxes and that you may have accumulated a significant nest egg that generates even more income in retirement than you had before you retired. So, in this scenario it would make sense to have tax-free income in retirement rather than getting less of at tax break while you’re working.

Unfortunately, it’s not that simple.

Using Roth IRA Assets to Pay Conversion Taxes

There are two different ways you can handle the taxes when you do a Roth conversion. Ideally, you would have funds already set aside outside the IRA that you can use to pay the taxes. This means your account value remains intact and you only have to pay the prevailing tax rate on the conversion amount. There’s also another way, and that’s to use the funds inside your IRA to cover the tax bill. Sadly, this is what a lot of people are choosing to do simply because they don’t have the money available to pay the taxes on the conversion. Big mistake.

First of all, if you choose to do this you’re actually taking a distribution from your IRA. Now, if you’re under 59 1/2 when you do this you’ll be subject to the 10% early withdrawal penalty. So, not only are you owing the regular taxes, but you are getting hit with an additional 10% penalty. If you use outside funds to pay the taxes this penalty wouldn’t apply. Second, using IRA proceeds to cover the taxes just reduces your account value. You could easily be faced with the fact that your account will be cut by about 40% just to do the conversion. How long would it take to recover from that?

Running a Few Different Scenarios

One of the tools I have through work is Blackrock’s Roth IRA conversion calculator. With this tool you get to plug in a bunch of numbers to create different scenarios to tell you whether or not a Roth conversion is the best choice. For this exercise I wanted to focus on the impact that paying the taxes from the IRA assets has on the conversion. Obviously, there were many scenarios where having a very low tax rate now versus a very high tax rate in retirement showed the Roth was the big winner, but I wanted to focus on a few more realistic scenarios.

For these scenarios all of the data is the same except for the tax rates before and during retirement:

• 35 years old at the time of the conversion
• Begin taking retirement distributions at 62
• Planning for 30 years worth distributions
• 8% returns pre-retirement
• 5% returns in retirement
• $100,000 account value

Assumptions:

The results assume that the taxes due when converting your current account to a Roth IRA are taken from the assets being transferred. It also accounts for the early withdrawal penalty on assets used to meet that tax liability. You do have the option of paying the tax liability out-of-pocket, which would affect the results. It further assumes that taxpayers at any income level may convert to a Roth IRA and that any tax liability arising from the conversion is paid in equal installments over two years, beginning with the 2011 tax year, at the same tax rate. These rules apply to conversions made during 2010. It also assumes that no distributions are taken before age 59½ and that you take even annual distributions during the retirement period you specified.

Roth Conversion at 28% Tax Rate Before and During Retirement

For the first example I wanted to see what would happen if tax rates didn’t change between the date of the conversion through retirement. I stuck with a middle of the road tax rate of 28%. As you can see, when you take money out of the IRA to cover the taxes and penalty you are left with a much smaller nest egg upon retirement when compared to leaving it in a pre-tax account. In this case, it’s nearly a $300,000 difference. Of course, when you break it out into annual withdrawals the impact is minimized, but you’d still be better off in this case to not do a Roth IRA conversion.

Roth Conversion at 25% Tax Rate Before and 28% During Retirement

What happens when your tax rate is higher in retirement? This is the classic example of when a Roth is the perfect retirement vehicle. Well, again we can see that because taxes were paid out from the IRA the damage done is hard to recover from. Even in this scenario there is a case that can be made to show that the conversion might not be the best idea.

Roth Conversion at 28% Tax Rate Before and 33% During Retirement

As tax rates increase both before and after, the gap narrows. Sticking with the pre-tax account virtually identical with the Roth just slightly losing out. But in reality and with variations that can’t be planned for I’d call this scenario as virtually equal.

Roth Conversion at 33% Tax Rate Before and 25% During Retirement

What happens when you bet wrong completely? All of the previous examples were showing tax rates the same or higher in retirement. But we simply don’t know what will happen decades from now. So what happens if tax rates end up being lower, or you make less in retirement therefore have a lower tax rate? Ouch! Making the wrong bet and using IRA assets to pay the conversion taxes cost you almost 20% overall.

Some Final Considerations

First of all, there are a lot of assumptions being made when it comes to long-term financial planning. Even though these examples kept everything constant across the board except for tax rates the real world will throw things in that can’t be predicted here or anywhere. You may retire earlier, or later. You may not be able to get the returns you expected leading up to retirement. You may not get the returns you expect in retirement. Your tax rates may change numerous times between now and retirement. Laws regarding retirement plan distributions may change entirely. There are many things we simply can’t plan for, so you need to keep that in mind when trying to weigh your options. Even what appears to be the best decision on paper today may come back to bite you in 30 years. The best you can do is make an informed decision.

This exercise wasn’t to make an argument against a Roth IRA conversion. Not at all. It was simply done to show the significant impact that using your account proceeds to pay the tax bill can have on the end result. Paying the taxes with outside funds is a completely different situation and the results are very different. Instead, this just throws a little information out there for those who were thinking about doing the conversion after hearing all the hype in the news and maybe didn’t think about where the money for taxes was going to come from.

Finally, keep in mind that even if you do have outside funds to cover the tax bill you want to make sure you’re not putting yourself into financial harm. If it’s going to take every penny of your emergency fund to pay the taxes on a conversion you’re putting yourself in a risky short-term situation only to try and maximize something in the future. In addition, even if you do spread out your tax bill across two years it may still end up bumping you into a higher tax rate, could end up subjecting you to AMT, or any number of tax complications.

My recommendation is to simply not take the decision to convert to a Roth IRA lightly. Unless your account is very small or you’re only converting a portion of your total retirement portfolio you should seriously consider getting some professional advice. Either from an accountant who handles your taxes or a fee-only financial planner you trust. They can help you navigate the waters of this important decision.

Related posts:

1. Eliminate Taxes With a Roth IRA
2. The American Workers, State, and Business Relief Bill of 2010 to Expand Roth 401(k) Conversions
3. Poll: How Do You Do Your Taxes?
4. Don’t Treat Your 401(k) Like a Savings Account
5. Last Minute IRA Tax Deduction