Roth Conversions even if you don't have the money to pay the taxes?

[qwerty3656]

Most of our money is in IRAs. I will have some room in the lowest tax bracket (12%) this year to do some IRA to Roth conversions, but would have to also pull money out to pay the taxes. Does this still make financial sense?

 

[SecondCor521]

I think most people here who have looked at this think it does.

Just remember that you will owe taxes on the total amount of the conversion even if you use some of it to pay taxes. So you will need to gross up the amount involved.

For example, if you conceptually are doing a $10K Roth conversion, you'll owe $1.2K in taxes on that (plus probably some state taxes). So you take out $11.2K. But then you owe taxes at 12% on $11.2K, so it becomes an even higher amount ($1,344). Don't worry, this doesn't go on forever - the math is just $10K / (1 - 12%) = $11,363.

 

[figuy1]

If most of your money is in IRAs, yes it's most likely best to fill up all of your 12% brackets with conversions.

Some exceptions may include:

People with lots in their taxable accounts might opt for tax gain harvesting their taxable equities to fill up their 0% LTCG bucket.

If you are living on a very tight budget (<$13k/ per person per year) and will always be under the standard deduction or other credits/deductions that will cause you to rarely pay taxes in the future.

If you are someone who is depending on certain programs that are based on AGI such as the ACA, might want to limit how many conversions they are doing to maximize subsidies. The loss in subsidies as you climb the AGI ladder may equate to an effective 20-30% marginal tax now rather than a 12% that the tax tables say you have. Some people with ACA subsidies try to convert up to the next "bend point" such as at 150%, 200%, or 250% of the FPL. If you're using ACA subsidies now, I'd likely not convert anything now unless you're sitting on a lot in your IRA, say >$2million.

If you are currently in a high-income tax state and plan on moving to a zero income tax state soon.

One way to find out your true marginal tax rate (including losses of subsidies/credits) is to use tax software and play with different conversion scenarios and see how your tax owed/refund changes. Sometimes there are some hidden deductions or credits for those with low AGI's such as EITC for some people that phase out at certain AGI's that you may be missing that you may not realize you are missing out on by doing the Roth conversions. It's not always as simple as $100 more in conversions = $12 in taxes.

 

[Perryinva]

Yes it does. ALL that matters is what tax rate you are paying (AND expect to pay) for money withdrawn. If the 12% bracket is something you rarely see (as in low) then always take advantage of it and then some. Using after tax funds to pay the taxes on a conversion simply increases the amount of the conversion by the tax amount. People live to say they have $2M in their IRAs when the reality is they really only “own” $1.5M of that money. The rest belongs to the IRS. The more of it you can “own” while only giving 12% to the IRS, the better. Unfortunately, the Catch-22 is those that have large IRAs, typically know how to invest, and find that the IRA grows as fast or faster than RMDs reduce it. This is fine if the long term plan was always to leave as much to heirs as possible, but if you actually wanted to USE the money you saved, then it’s a different story.

So if you found yourself in the same predicament as many, you didn’t realize until too late that always deferring taxes for a benefit now, actually meant no benefit later or even could have cost you money! Plenty of people with large IRAs find themselves with more taxable income in retirement with SS, pension, investment, and RMD income than they had while working!! So they saved some small taxes while in the 15% bracket when young and now have to pay to get that same money out, in the 27% bracket after a successful career and retirement.

 

[RunningBum]

Beware that if you are not yet 59.5 you can convert to your Roth, but the taxes paid from your tIRA for the conversion is considered a withdrawal and likely comes with an early withdrawal penalty. Someone can correct me if my understanding is wrong.

Otherwise, if it made sense with taxes paid from a taxable account, it still makes sense with taxes paid from the tIRA. You just get slightly less benefit because you aren't able to convert every dollar out of the tIRA into the Roth.

 

[pb4uski]

Most of our money is in IRAs. I will have some room in the lowest tax bracket (12%) this year to do some IRA to Roth conversions, but would have to also pull money out to pay the taxes. Does this still make financial sense?

Yes, but only if you are 59 1/2 or older so the withdrawals to pay the tax are not subject to the 10% early withdrawal penalty.

Some of the reasons... once you start pensions or SS you will likely be in a higher tax bracket. Lower personal income tax rates are scheduled to sunset in a few years so it is more likely than not that future tax rates will be higher. If you or your DW were to die prematurely, the surviving spouse will likely be in a much higher tx bracket.

 

[qwerty3656]

I didn't realize that money used to pay the taxes is subject to 10% penalty (if you're not 59 1/2 - which I'm not). That complicates things. I have substantial Roth IRA money - I would have to withdraw Roth IRA money to pay the taxes - I wonder if that gets too cute (ie deposit IRA money into Roth and withdraw "different" Roth money to pay taxes)

 

[gauss]

^ I believe that this is indeed allowed.

Just make sure that the Roth funds you are withdrawing are penalty free.

gauss

 

[SecondCor521]

I didn't realize that money used to pay the taxes is subject to 10% penalty (if you're not 59 1/2 - which I'm not). That complicates things. I have substantial Roth IRA money - I would have to withdraw Roth IRA money to pay the taxes - I wonder if that gets too cute (ie deposit IRA money into Roth and withdraw "different" Roth money to pay taxes)

Right, it would be, unless you qualify for one of the exceptions to the early withdrawal penalty (which you probably wouldn't, but see instructions for Form 5329 line 2).

But the 10% penalty is only on the amount you don't convert. That is, the 10% penalty is only on the amount withdrawn for taxes. So in the example from post #2, you could convert $11,363 from your traditional IRA to your Roth IRA and use $1,163 of that conversion to pay the 12% in income taxes. You'd then owe 10% of $1,163 as an early withdrawal penalty, but that is only $116.

Obviously for larger conversions, that $116 would also be larger. But it's only about 1% of the amount converted, so maybe you could find some other funds to pay it.