Rethinking the Paying of Roth Conversion Taxes

[RetireBy90]

So up until recently, I have looked to Roth conversions as a way to lower my tax bill and RMDs later in my retirement years. Many have advised and discussed paying for Roth conversions from cash or non-IRA funds which I have been doing. However, what if we were to look at the conversions as a way to dispose of a pending tax liability come RMD day ? If I were to pay for conversions with a draw from the TIRA that would further reduce the liability on top of the conversion. I understand there is taxes to be paid on the draw so I would need to increase the total amount to account for taxes (Fed and State). However, it would get me to my goal of reducing the TIRA tax liability sooner and leave the after tax account funds for living expenses.

The discussions that included those that take an IRA draw at end of each year with 100% withholding to pay the tax man. This got me thinking of what is my goal, and what is the impact of an extra $25K draw from TIRA on my overall situation.

Curios what the views are of others. Just spitballing here, see what views come out.



Off Topic, shouldn't TIRA and RMD be in the spellcheck dictionary ? ha


Thanks

 

[Sunset]

I agree if the IRA is huge. After all at some point a person is going to be forced to RMD it.
What number a huge IRA is, depends on the other income (taxable rate) a person will end up with.
Big factors are SS and Pension.

However, the ideal case (IMHO) is for an specific situation:
Small to Medium sized IRA, relative to years available.
Large taxable $$ account.
X number of years before RMD.

Here convert all in IRA up to certain amount left in IRA $100K->$400K.
Pay with taxable $$$ to maximize amount going into ROTH at acceptable taxable rate.

When done have for example have
IRA = $200K (for future withdrawals with medical deductible expenses = low taxes).
Roth = $X00K
Taxable = few $100K left over.

 

[Sunset]

Other factors play into it, example the taxation by the State.

I'm taking IRA withdrawals for spending, while we do conversions to roth.

Because our State (IL) does not tax (5% State tax) IRA withdrawals, but would tax Capital gains, so we are paying less tax for now, and maybe we will move to a Tax free State and can then sell the Capital gains without paying the 5%.

 

[pb4uski]

I convert to the top of the 0% preferenced income tax bracket, so whether I pay the tax through withdrawals or from taxable funds would not impact the amount withdrawn from the tIRA.

By paying the tax from taxable funds you end up with more in the Roth.

 

[RetireBy90]

I convert to the top of the 0% preferenced income tax bracket, so whether I pay the tax through withdrawals or from taxable funds would not impact the amount withdrawn from the tIRA.

By paying the tax from taxable funds you end up with more in the Roth.

My income, from small pensions, DW SS, and rental property, when combined will keep us in 22% bracket.

Guess my question is what are thoughts on paying taxes with a withdraw from the TIRA. I would Still pay 22% tax on conversion and on withdraw.

 

[Cobra9777]

It's been demonstrated many times that the optimal solution is to pay conversion tax with separate taxable funds. For a specific conversion amount, you end up with more in the Roth. And that's a good thing. In effect, it's like a transfer from the taxable account into the Roth, where those funds will escape taxation forever.

If you want to convert more or faster, that's fine. But once you've decided how much to convert, pay the tax from separate taxable funds if you can. For many, the benefit is rather small compared to the rate differential. But there's no question it's the better solution because you end up with more in the Roth.

 

[jollystomper]

Guess my question is what are thoughts on paying taxes with a withdraw from the TIRA. I would Still pay 22% tax on conversion and on withdraw.

I have not done a lot of Roth conversions, but this is what I have done so far. It is not be the best way, but my tIRA is my largest financial account. Even if I convert to the top of my bracket before RMDs hit it will still be my largest account. Drawing it down for this purpose suits me fine.

We are in the 22% tax bracket and I track our tax liability throughout the year to estimate what we will owe in taxes (of which any performed/planned Roth conversions are part of it). During what I deem are "up" times in the market (yeah, you can call it market timing) I make withdrawals specifically towards the taxes (including what the withdrawal would be taxed at).

Last year I did this for the first time, and it worked well for me. The tax withdrawals were slightly more than %1 of the tIRA value. So far this year I have done this in February when the market was at all time highs, and again during the recent rebound.

 

[FREE866]

I did my first Roth conversion last week and next year will pay taxes from outside cash funds. Like stated above, every article I read said that makes the most sense. I like the idea of all that money at work in the Roth where it can grow as large as possible and tax free.

 

[RetireBy90]

I understand paying taxes from after tax funds will have effect of more in an IRA. I have done that last 2 years. Not the point.
There are several reasons I’m doing conversions. Save $$ by paying tax now before rates go up after 2025; save $$ by paying taxes now rather than when RMDs kick us into higher bracket; reduce future uncertainty when one of us passes and remaining spouse has to pay tax rate at single rate; allow for pulling $$ from IRA at my schedule without paying an increased tax bill; Reduce tax complexity if DW survives me; and reduce taxes that may be due to heirs. Lots of reasons to convert.

 

[CardsFan]

My income, from small pensions, DW SS, and rental property, when combined will keep us in 22% bracket.

Guess my question is what are thoughts on paying taxes with a withdraw from the TIRA. I would Still pay 22% tax on conversion and on withdraw.

If you are looking to draw down the tIRA as a primary goal, and will be in the 22% bracket anyway, I don't think it much matters.

My personal opinion is that there are way too many moving parts to think I can come up with the perfect plan to optimize the tax efficiency of tIRA withdrawals. You can play the odds, but that is all you are doing.

Withdrawing up to the the top of the 12% bracket is a no brainer. I will never be at 12% after RMD's, no matter what I do. I have paid the taxes both ways, from after tax and from the IRA. Going forward, it will be from after tax.

JMHO. Others will undoubtedly disagree

 

[RetireBy90]

If you are looking to draw down the tIRA as a primary goal, and will be in the 22% bracket anyway, I don't think it much matters.

My personal opinion is that there are way too many moving parts to think I can come up with the perfect plan to optimize the tax efficiency of tIRA withdrawals. You can play the odds, but that is all you are doing.

Withdrawing up to the the top of the 12% bracket is a no brainer. I will never be at 12% after RMD's, no matter what I do. I have paid the taxes both ways, from after tax and from the IRA. Going forward, it will be from after tax.

JMHO. Others will undoubtedly disagree

Thanks. My situation is as you describe, paying IRMAA, tax hit on SS, deduction do depreciation on rental phases out, lots of moving pieces and the rules of the game most certainly will change every year. I’m just trying to take care of most of the tax hit. Once RMDs kick in we can take QCD If need be for that year and not mess with taxes due.

 

[pb4uski]

My income, from small pensions, DW SS, and rental property, when combined will keep us in 22% bracket.

Guess my question is what are thoughts on paying taxes with a withdraw from the TIRA. I would Still pay 22% tax on conversion and on withdraw.

What will your tax bracket be once you start SS? I'd probably convert or withdraw to the top of that tax bracket and pay the tax from taxable in conversions if you can, otherwise from withholdings. Why you ask? Because if you or your DW dies then the surviving spouse's RMD's will be in an even higher tax bracket.

 

[RunningBum]

Method 1, the commonly advised method here on the board and other places:

Convert to the top of the 22% bracket, pay taxes out of taxable.

Method 2, your spitball method:

Convert part of the way into the 22% bracket, and withdraw to the top of 22% for taxes.

Both methods reduce the tIRA by the same amount. You seem to think your method 2 reduces it more. It doesn't. Or at least it shouldn't if you are doing it right.

Method 1 puts more money into the Roth, by the amount of the taxes due on the conversion. Method 2 leaves more money in your taxable account, by the same amount. I would much rather have money in a Roth, where it grows tax free forever, than in my taxable account where I pay taxes on dividends, and capital gains if I ever sell what I'm holding.

The only reason I wouldn't do Method 1 is if I didn't have enough money in taxable to pay the taxes, or I haven't yet hit the 5 year rule and might need that money sooner.

 

[CRLLS]

I am doing the Roth conversions paying taxes from the Ira. This is for several reasons. 1st is I don't have after tax money to pay the taxes so it is either pay them from the IRA or don't do any conversions. 2nd reason is, like you, I want to reduce the RMD's and the resultant taxes. The 3rd reason (actually 2nd part of #2) is I am married and if one of us passes first, the survivor filing single will really be hit tax wise.

I don't convert to the top of the 22% bracket. I convert and pay taxes up to the IRMAA trigger.

 

[Cobra9777]

...Guess my question is what are thoughts on paying taxes with a withdraw from the TIRA...

I understand paying taxes from after tax funds will have effect of more in an IRA. I have done that last 2 years. Not the point...

Huh? You specifically asked about paying conversion tax by making an IRA withdrawal as opposed to using taxable funds. That's the title of the thread! How is that not the point?

You then posted a laundry list of generic reasons people do Roth conversions, none of which have any bearing on the question of which funds to withdraw to pay conversion tax...

...There are several reasons I’m doing conversions. Save $$ by paying tax now before rates go up after 2025; save $$ by paying taxes now rather than when RMDs kick us into higher bracket; reduce future uncertainty when one of us passes and remaining spouse has to pay tax rate at single rate; allow for pulling $$ from IRA at my schedule without paying an increased tax bill; Reduce tax complexity if DW survives me; and reduce taxes that may be due to heirs. Lots of reasons to convert.

This forum is littered with generic Roth threads that cover all the reasons to convert. But you asked a very specific question about which funds to use when paying conversion tax. It's a fair question. People took the time to answer. Either you didn't like the answers, or you didn't understand them, or you intended to ask something different. Either way, it seems a bit odd to subsequently claim they are "not the point."

 

[Animorph]

IF all of your Roth conversion and RMD withdrawals will occur within the same tax bracket and you pay the taxes with tIRA money then the conversion has no benefit or loss. If your future tax rate increases (legislative changes or a surviving spouse) you will have some benefit by converting now at a lower tax rate. Seems reasonable enough to give it a shot.

But it is also that chance to get some of your taxable account money into the Roth, for free, and if you meet the Roth withdrawal requirements you may also be able to take it back out at any time. So there's not a big risk there. The only problem I've thought of is if taxable money goes into the Roth and you incur a capital loss, which now can't lower your taxes. So a possible benefit if you pay taxes on your taxable account, with minimal downside. Sorry for the pay with taxable account ad!

 

[RetireBy90]

My point is that if I pay taxes from the TIRA then it would move more funds from that account and further reduce the balance. This would reduce my RMDs and unpaid tax hit.



As was pointed out by RunningBum, if I wanted to further reduce the TIRA it is better to just convert more. It took a while after reading that to let it bounce around my head and it is a better option. Only advantage left is that if I were to pay taxes from TIRA is not worried about quarterly tax payments. Guess I'll just suck it up and pay the 4 installments.



Thanks

 

[Austin704]

When I did a Roth conversion this year, I decided to pay half the taxes from a taxable account and the other half by taking a small distribution from a tax-deferred 457, which automatically withheld 20%.

This allowed me to reduce the hit to my taxable accounts while still getting the full benefit of 100% of the tIRA conversion going into the Roth. The 457 allows penalty free withdrawals, but of course the distribution had to be included in my taxable income for the year, so if you are close to the top of your conversion bracket this move could limit what you can convert.

The other benefit is that it reduced my 457 balance somewhat. The way I figured it, taxes have to be paid on that $$ some day and taking a small distribution now was less painful than paying the full amount from taxable.

Just another option...

 

[Animorph]

My point is that if I pay taxes from the TIRA then it would move more funds from that account and further reduce the balance. This would reduce my RMDs and unpaid tax hit.

Usually the Roth conversion amount is what fits within a tax bracket or income limit. So the amount withdrawn from the tIRA is set by that. You could then pay taxes with some of that withdrawal, or not. An additional withdrawal on top of that original amount, specifically for taxes, would come at a higher tax cost in this case. That may be one reason we're having trouble with the way your problem is structured.

I pretty much optimize just one variable for my retirement plan, tIRA withdrawals. They're the one big tax driver I have control over. I optimize them to generate the highest inflation adjusted yearly income I can, with an inflation-adjusted ending balance many years in the future. If I need the income (when I run out of taxable account funds), I use that withdrawal for expenses. If I don't need the withdrawn funds they are Roth converted (taxes paid quarterly from taxable accounts to maximize the Roth balance). If I still need additional income after the tIRA withdrawal then I'll start Roth withdrawals. In that sense the Roth and taxable accounts serve the same purpose, filling in gaps between income and expenses nearly interchangeably. The Roth account is just a little better, being tax-free, and hence is used last.