Q. Hi, Dan: Very informative column making the case for not paying Roth IRA conversion taxes with money from one’s IRA. For those like myself with no money outside their IRAs, I still see some reasons for paying the taxes with IRA money: Taking advantage of low tax rates, in my case, 12%, reducing one’s traditional IRA balance to lower RMD amounts, and building up Roth balances through conversions. Am I totally off-base?
— Lisa
A. Thanks Lisa. You are not off-base. It is better to pay the taxes on a conversion with non-IRA funds because doing so maximizes the amount of money in the tax-free environment of a Roth and lowers the amount of money in the taxable environment of a non-retirement account.
Nonetheless, for those who have do not have enough in taxable accounts to pay the taxes, a conversion can still make sense.
Regardless of from what type of account you pay the taxes, a conversion can still be good if the tax rate you pay on the converted money ends up being lower than whatever rate would apply when you took distributions from the IRA later.
We need to look at two tax rates. The present rate (P) and a future rate (F). If P is expected to be lower than F, a conversion should be considered.
P is a lot easier to assess than F. The main issue is, what do you think your F will be and how confident are you of that estimate?
For instance, if you are leaving your IRA to your church and you are confident that will largely always be the case, a large portion of your F is going to be zero because such charitable bequests are not taxed.
Most people default to thinking rates are going up because they are so low now and the tax code will change. That generalization is not the issue. What is relevant is that rates must change in such a way that your F is higher than your P for a conversion to pay off.
Obsessed with retirement? Read Retirement Weekly
I see quite a few people in high tax brackets thinking rates are going higher or fearing RMD performing conversions without accounting for the drop in their incomes when they retire or the tax brackets their spouse and other heirs would likely be in.
You mentioned that your P is 12%. That’s pretty low so you are wise to be thinking about these things. Keep in mind that if you are under 59 ½ your P is higher due to a penalty. Try not to convert so much as to go substantially into a higher bracket and don’t forget that with the new tax code, conversions can’t be recharacterized (reversed). This makes good tax planning even more valuable. Get some real help if you need it.
If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line.
Dan Moisand’s comments are for informational purposes only and are not a substitute for personalized advice. Consult your advisor about what is best for you. Some questions are edited for brevity.
