The Journal of Accountancy named 2010 “The Year of the Roth Conversion” as the media aroused public interest by touting potential tax savings. Unfortunately, many taxpayers and even advisors were so caught up in the excitement that they pulled the conversion “trigger” without considering the entire financial impact on the client. Our position is that, depending on your unique financial “DNA,” converting from a traditional retirement account to a Roth may cost you more in the long run.
At the risk of this article turning into the financial equivalent of water-boarding … let's say you're 40, married, and live in California with $69k of taxable income. This puts you into the following tax picture:
Taxing AgencyLevel 1
Income Tax
Level 2,
Pre Age 59 1/2
Early Withdrawal Penalty
Federal 25%10%
California 6.25%2.5%
Because Roth Conversions are excluded from the Level 2 penalties, $32k of a regular IRA converted into a Roth would generate about $10k in tax. “No problem,” you say, you have enough in your IRA to cover it. But if you pull funds from a retirement account to pay the tax due on from the conversion, you will have to pay tax at both Level 1 and Level 2 on the second withdrawal. That's almost $18k in taxes or a 44 percent tax rate!
It's the loss of earnings on this $18k over your lifetime that really drags down the benefit of a Roth Conversion. At age 65, the scenario above would provide less retirement income if the taxes are pulled from the IRA, but more income if the tax is paid with non-retirement funds.
The good news is that you can change your mind and undo the decision up until your tax filing extension deadline by having your IRA custodian flip the funds back. It's a little more complicated than that but the length of this article doesn't allow for a full explanation.
Number geeks like us hate to give advice out of context, so the closest we will come to a general answer about Roth IRA Conversions is as follows: If you are over 40, in a high tax bracket and don't have money hanging around to donate to the IRS — think twice. But beware of rules of thumb or listening to “Talking Heads” for financial advice, on any level that's a bad idea and leads to unanticipated results. It is the killer of comfortable retirements.
If you don't know what's right for you, find someone who can help and understands your full financial picture. For a list of professional resources in your area, go to www.fpanet.org or www.napfa.org. For more information on the assumptions and conclusions used in this article, please email [email protected].
The Financial Team can be reached at (760) 448-2882.
At the risk of this article turning into the financial equivalent of water-boarding … let's say you're 40, married, and live in California with $69k of taxable income. This puts you into the following tax picture:
Taxing AgencyLevel 1
Income Tax
Level 2,
Pre Age 59 1/2
Early Withdrawal Penalty
Federal 25%10%
California 6.25%2.5%
Because Roth Conversions are excluded from the Level 2 penalties, $32k of a regular IRA converted into a Roth would generate about $10k in tax. “No problem,” you say, you have enough in your IRA to cover it. But if you pull funds from a retirement account to pay the tax due on from the conversion, you will have to pay tax at both Level 1 and Level 2 on the second withdrawal. That's almost $18k in taxes or a 44 percent tax rate!
It's the loss of earnings on this $18k over your lifetime that really drags down the benefit of a Roth Conversion. At age 65, the scenario above would provide less retirement income if the taxes are pulled from the IRA, but more income if the tax is paid with non-retirement funds.
The good news is that you can change your mind and undo the decision up until your tax filing extension deadline by having your IRA custodian flip the funds back. It's a little more complicated than that but the length of this article doesn't allow for a full explanation.
Number geeks like us hate to give advice out of context, so the closest we will come to a general answer about Roth IRA Conversions is as follows: If you are over 40, in a high tax bracket and don't have money hanging around to donate to the IRS — think twice. But beware of rules of thumb or listening to “Talking Heads” for financial advice, on any level that's a bad idea and leads to unanticipated results. It is the killer of comfortable retirements.
If you don't know what's right for you, find someone who can help and understands your full financial picture. For a list of professional resources in your area, go to www.fpanet.org or www.napfa.org. For more information on the assumptions and conclusions used in this article, please email [email protected].
The Financial Team can be reached at (760) 448-2882.