When converting a traditional individual retirement account to a Roth, there may be significant advantages to paying the taxes with funds not involved in that investment, according to tax experts.
Traditional IRAs require taxes to be paid when funds are withdrawn, whereas taxes are paid before the money enters a Roth, allowing investments to grow tax-free. Paying with funds not involved with the conversion, if possible, allows for greater compounding over the life of the Roth.
"If you're paying the money out of your IRA to pay the tax bill, it doesn't make sense because you're getting hit with taxes now, and it would have been better to just let that money continue to grow tax-deferred rather than pay now and convert," Kevin Knull, CEO of Dallas-based TaxStatus and cofounder of Advice.ai, said in an interview. "It snowballs on itself, if you will. So you really should pay the conversion tax out of an after-tax account."
Paying the conversion tax out of the IRA itself would limit tax-free growth opportunities.
"If you convert the money and you have the taxes debited from that account, for example, you lose growth opportunities, tax-free growth opportunities," said Miklos Ringbauer, founder and principal of MiklosCPA, an accounting and tax firm based in Southern California.
Another advisor agreed while cautioning that it isn't an absolute rule.
"I would say that it's a good idea if possible," David R. Silversmith, a senior manager of private client services at New York City-based Eisner Advisory Group, told Financial Planning in an email. "However, everyone's tax situation is different. I still believe it's always best to give your CPA a heads up before doing a Roth conversion in case there are other factors that the client is not considering."
When to do a Roth conversion
Although individual client circumstances vary, Knull said
One reason to convert is if a client has a large IRA balance that would require making larger
Generally, advisors would recommend that a client convert traditional IRAs to Roths if the client anticipates having a higher tax bracket in retirement than currently, Silversmith said. Another reason is if the client anticipates a spike in itemized deductions in the current year, such as from a catastrophic accident leading to a large amount of medical expenses.
Ringbauer has had clients who want to take a sabbatical from work for one or two years, and that can be a good time to do a conversion because of being in a lower tax bracket. Another opportune moment could be when retirees have a gap year or years between retiring and having to start taking RMDs or claiming Social Security benefits.
After starting to take RMDs, clients could still do a Roth conversion but have another potential landmine to watch for.
Clients converting IRAs to Roths in a year when they have to take an RMD should be cautious to make the conversion an amount in addition to the RMD to
For advisors with high-income clients, a strategy referred to as a
If a client has already maxed out a 401(k) account with pretax dollars, he or she might want to make a nondeductible traditional IRA contribution and then immediately convert to a Roth before the IRA contribution earns income and therefore generates taxable income, Ringbauer said. Getting tax guidance is important to avoid mistakes, he added.
When a Roth conversion might not be a good choice
If a client is already in the 37% tax bracket, then there is "no point" in converting to a Roth, Silversmith said.
Similarly, Ringbauer cautioned against converting all at once because having a large amount of taxable income associated with the conversion could push a client up into a high tax bracket.
Knull recommended considering whether the Medicare Income-Related Monthly Adjustment Amount surcharge will apply two years after the conversion. Also, clients should consider the 3.8% tax on net investment income, premium credits for health insurance, the "pro rata rule" and phaseouts from the July 2025 tax law such as the new senior deduction.
"If the client has after-tax basis sitting in a traditional IRA, and nobody's tracking it, you could even have part of that conversion taxed twice," he said.
"It's worth it to spend an hour or two and pay for their services, whether it's an enrolled agent or a CPA," Ringbauer said. "You make sure that you understand the hidden traps," unexpected taxes or lost benefits.
Also, to avoid taxes, clients must avoid withdrawing converted funds for five years. If they withdraw too early and are younger than 59 ½ years old, they will also owe a 10% penalty.
READ MORE:
Advisors should be careful to consider the various potential issues before clients go through with Roth conversions.
"Once you convert, because the recharacterization was eliminated, you can't change your mind," Knull said. "A lot of these discoveries will happen a couple years from now," and clients will discover additional taxes and issues.
It is important to have "really accurate, real-time data to make these decisions," such as adjusted gross income, effective tax rates and all income, he added.
"It's more than just having a conversation with a client. You have to do a lot of homework to make sure that you've got what you need to make a good decision," Knull said. "Getting that accurate data can help these advisors avoid some very costly mistakes."
