Roth Conversions: Paying Tax Now to Skip It Later

Most retirement money in Parker County sits in traditional IRAs and 401(k)s, contributed pre-tax and waiting to be taxed on the way out. A Roth conversion flips that: you move some of that money into a Roth account, pay income tax on the amount now, and the account grows and is withdrawn tax-free afterward. Done in the right year, it is one of the most effective planning moves available. Done carelessly, it is an unnecessary tax bill. Here is how to tell the difference.

What actually happens in a conversion

You direct the custodian to move a chosen amount from a traditional IRA, or from a former employer's plan, into a Roth IRA. The amount converted is added to your taxable income for the year, taxed at ordinary rates, and reported to you on a 1099-R the following January, a form we explain in Form 1099-R. There is no early withdrawal penalty on a conversion regardless of your age, because the money stays in a retirement account. From that point, qualified withdrawals from the Roth, including all future growth, are not taxed.

You can convert any amount, in any year, in as many pieces as you like. There is no income limit on conversions, which is why they are available to people who earn too much to contribute to a Roth directly.

Why anyone would pay tax early

The logic is simple. Money in a traditional account will be taxed eventually, at whatever your rate happens to be when it comes out. If you can pay the tax today at a lower rate than you expect to face later, converting wins. The years when that is most likely:

• A low-income year. A gap between jobs, the year a business had a loss, early retirement before Social Security and required distributions begin. Income that would normally be taxed in a higher bracket can be pulled into a lower one.
• The years between retirement and required minimum distributions. Many retirees have a window where their income is modest and their traditional balances are large. Converting steadily during that window reduces the required distributions later, which can also affect how much of their Social Security is taxed.
• When you expect rates to be higher later, whether because of your own income, your heirs' income or the law.
• For heirs. Beneficiaries of a Roth IRA inherit tax-free withdrawals, which can be a meaningful gift when the alternative is a taxable inherited IRA on a compressed withdrawal schedule.

The mistakes that cost money

Converting too much in one year. A conversion stacks on top of your other income, and a large one can push you into a higher bracket, which is the opposite of the goal. Partial conversions sized to fill a bracket, repeated over several years, are the usual approach.

Paying the tax from the converted money. If the custodian withholds tax from the conversion, the withheld amount never makes it into the Roth, and if you are under the early withdrawal age, the withheld portion can be treated as a distribution subject to penalty. Pay the tax from outside funds whenever possible.

Forgetting the other thresholds. Conversion income counts for Medicare premium surcharges, which are based on income from two years earlier, for the taxation of Social Security benefits, and for income-based credits and deductions. A conversion that looks fine in the bracket table can trigger costs elsewhere on the return. We discuss the ordering problem in The Order You Withdraw From Retirement Accounts.

Ignoring the five-year rules. Converted amounts have their own five-year clock before they can be withdrawn penalty-free if you are under the early withdrawal age, and the Roth account itself has a five-year requirement before earnings are tax-free. Neither is a problem for someone who does not need the money soon, but they matter for anyone planning to spend it.

Assuming you can undo it. Conversions used to be reversible. They are not anymore. Once the money moves, the tax is owed.

The pro-rata rule

If you have ever made non-deductible contributions to a traditional IRA, a portion of every conversion is tax-free, but the portion is calculated across all your traditional IRAs together, not just the one you convert from. People who try to convert only the after-tax dollars find that the rule taxes part of it anyway. The records that track non-deductible contributions across years are what make this calculation possible, and they are commonly lost.

Estimated tax and timing

Because the tax is not withheld, a conversion often requires an estimated payment or a withholding adjustment elsewhere to avoid an underpayment penalty. Conversions also have to be completed by December 31 to count for the year, and custodians get busy in December, so the decision belongs in the fall. The safe harbor rules in Safe Harbor: How to Stop Worrying About Underpayment Penalties are worth knowing before the first one.

Running the numbers

A conversion is a projection: this year's income, next year's, the years until distributions start, and a reasonable guess about rates. It is not a rule of thumb. We run these projections for clients across Weatherford, Hudson Oaks and Granbury each fall, and the most useful ones are for people in the first few years of retirement who have not yet started Social Security.

This article is general information, not tax or investment advice. Bracket thresholds, Medicare surcharge tiers and the age rules change, so confirm the figures for your year before converting.

Thinking about a conversion this year? Call RD Precision Tax Service in Weatherford at (817) 480-6649, or request a free estimate. Tax planning before December is when this decision is worth making.