How to Pay Taxes On A Roth Conversion

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The Roth is loved by investors and financial advisors alike, and for good reason. The benefits the Roth offers are hard to ignore, so it’s no wonder many Americans would like to convert their savings to Roth and get on the tax-free retirement path. But how will you pay the tax bill you could incur upon conversion? This is where informed financial planning and smart tax forecasting come into play, ensuring that your conversion to a Roth IRA doesn’t come with unexpected penalties or further tax bills. And after the end of this article, you may decide that while a Roth conversion sounds enticing, it’s simply unrealistic due to the burdens one would impose on your finances. 

Retirement Plan Funding

The Roth IRA

When contributing to a Roth, you typically finance it with post-tax funds from your salary or other income source. In exchange for paying your taxes immediately, you gain the privilege of tax-free growth and tax-free withdrawals in retirement. Your withdrawals don’t affect your AGI (which could affect Social Security benefits and Medicare premiums), and you don’t have to begin withdrawing funds at a certain age (known as Required Minimum Distributions). 

The Traditional IRA

The Traditional IRA is funded in the complete opposite way of a Roth IRA. First, you contribute to the account before paying taxes and claim a deduction from your income, potentially keeping you in a lower tax bracket. However, you’ll have greater tax burdens in retirement – withdrawals are considered taxable income and will affect your AGI, and you’ll have to start withdrawing from your account at age 73 (as of 2024), potentially negatively impacting your financial plan. 

Converting from Traditional to Roth

You may have never contributed to a Roth, or perhaps you would like more of your Traditional savings to be reclassified as Roth. That’s where a Roth conversion comes in. 

If you have already read our previous article on Roth conversions, you may have a good idea of whether or not a conversion makes sense for your unique situation. If not, you can read it here

And if you’ve decided a conversion may make sense, it’s time to figure out how to pay the tax bill.  As you’ll owe tax on both the contributions and any earnings you’ve accumulated, the tax bill may be pretty hefty and potentially push you up a tax bracket.

How to Pay Your Roth Conversion Tax Bill

Here are the most common ways to pay your conversion tax bill in a general order of efficiency: 

Your Savings

Usually, it makes the most sense to pay your tax bill outright with liquid capital you already have on hand. That way, you don’t have to worry about having to sell assets to make up for it – doing so would potentially generate its own tax burden and give you fewer assets to yield compound gains. 

However, would a sudden loss of liquid capital put your finances at risk?

Pulling from an emergency fund is risky, and if something were to happen before you could replenish it, you may find yourself full of regret. Alternatively, if your funds aren’t specifically set aside for something else, perhaps you would gain more in the long run by simply investing via a brokerage account and not touching your assets in your Traditional IRA.

Use Non-Retirement Account Assets

If you’ve determined that a Roth conversion is indeed the ideal path for your retirement funds, but you don’t have the cash to pay your tax bill (or paying in cash would put you in a financial risk zone), the next possible alternative would be to liquidate assets in your non-tax advantaged brokerage account. Unfortunately, you’ll likely owe a tax bill on those funds as well, meaning your assets will need more time to recover from the financial blow. 

However, there are ways to help minimize the tax burden:

1. Sell assets you’ve held for longer than a year. 
You’ll pay the lower capital gains tax rate by selling assets you’ve had for over a year. Assets held for less than a year incur short-term capital gains, which are taxed the same as ordinary income.
2. Harvest Your Losses
You may have sold assets at a loss, and by claiming those losses, you’ll help offset your tax liability on the sale of your assets.

Use Retirement Account Funds

This is often the least ideal variant. Any funds you withdraw that aren’t deposited into a Roth account will face a 10% penalty if you are under 59.5 years of age and not qualified for any exceptions. So, if you sell extra assets to pay your tax conversion, those funds will be penalized, meaning you’ll have to sell even more assets to help make up for that fact, increasing the amount of time to recover to your pre-conversion levels. 

Points to Consider

Is a Smaller Amount More Affordable?

If you don’t have the funds to convert your desired amount and other methods would harm your tax and investment strategy, you may consider staggering your conversions over a few years. This will reduce your immediate tax burden into more manageable chunks and potentially keep you in a lower tax bracket. 

Will You Need Converted Funds Within Five Years?

After transferring to a Roth account, you’re facing a five-year wait to access the funds penalty-free. Moreover, if you’re using retirement savings to settle your tax bill, it’s wise to wait until your balance returns to its pre-conversion level, if feasible. A financial advisor can provide a break-even analysis to help predict when your balance could realistically or potentially recover.

What's the state of the market?

When paying your tax bill by liquidating assets, converting during market peaks means a tougher climb back to your original balance. It might be more prudent to convert during a market low. 

Final Thoughts

Even if you feel converting to Roth would be highly beneficial to your retirement, failing to account for your tax bill could cause significant harm to your financial plan. The methods we’ve thus far mentioned are only a few possibilities to pay your tax bill – your own financial situation may yield other solutions that could make a conversion feasible. 

Instead of trying to figure it out on your own, we recommend getting rid of the guesswork and sitting down with a financial advisor who can help you determine not only if a Roth conversion is appropriate but also how to pay your taxes in the most efficient manner possible.

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