Ranking the Best-to-Worst Ways to Pay Your Roth Conversion Taxes
Roth conversions have gained popularity as a strategic move for tax planning. By converting traditional retirement funds to a Roth IRA, you pay taxes on the converted amount now, allowing for tax-free withdrawals in retirement. However, many individuals overlook the critical decision of how to pay the taxes incurred from this conversion. Below, we rank the best-to-worst ways to pay these taxes, considering their implications for your financial health.
1. Out of Pocket (Using Cash Savings)
Best Option: Paying your Roth conversion taxes out of pocket with cash savings is the best strategy. By using your own funds, you can avoid dipping into your retirement accounts, ensuring that all converted assets continue to grow tax-free. This method helps you maximize the benefits of your Roth conversion without incurring additional debt or penalties.
Pros:
- Preserves retirement accounts for future growth.
- Avoids potential penalties and taxes on withdrawals.
- Ensures no debt is accrued.
Cons:
- Requires sufficient cash reserves, which some may not have on hand.
2. Using Non-retirement account Funds
Second Best Option: If you don’t have enough cash savings, using funds from a non-retirement investment account (such as a brokerage account) can be a viable option. This allows you to pay your taxes without affecting your retirement savings. However, consider the potential capital gains tax implications when liquidating investments to fund the tax payment.
Pros:
- Maintains tax-advantaged status of retirement accounts.
- Flexible options, as many investments can be sold when needed.
Cons:
- Possible capital gains taxes if selling appreciated assets.
3. Withholding from the Conversion Amount
Middle Tier Option: If you choose to withhold a portion of the converted amount to cover taxes, this can make the immediate financial burden lighter. However, this method reduces the amount converted into the Roth, which may impact potential tax-free growth in the future.
Pros:
- Easy to handle, as it’s managed during the conversion process.
- No need for upfront cash.
Cons:
- Reduces the total funds benefiting from tax-free growth.
- May lead to inadequate withholding if not planned correctly.
4. Taking a Distribution from a retirement account
Near the Bottom: Taking a distribution from another tax-advantaged retirement account (like a 401(k) or another IRA) to pay your Roth conversion taxes is not a recommended strategy. This can lead to immediate tax liabilities and potential penalties, especially if you’re under the age of 59½.
Pros:
- Can have a large sum available if needed.
Cons:
- Immediate tax consequences and potential penalties.
- Detracts funds from your retirement savings.
5. Using a Loan
Second to Worst Option: Borrowing money to pay for your Roth conversion taxes is a risky approach. While it may seem like an easy way to bridge the gap, it can lead to high-interest debt. If your investments perform well, the debt can become more manageable. However, if the market underperforms, you may find yourself in a financial bind.
Pros:
- May provide immediate cash flow during tax payment.
Cons:
- Accrual of debt with interest.
- Potential strain on long-term financial standing.
6. Waiting and Paying Taxes Later
Worst Option: Delaying tax payment on your Roth conversion taxes can lead to estimated tax penalties and interest charges. This strategy assumes you control these penalties, but tax authorities will not be sympathetic to cash flow issues when deadlines are missed.
Pros:
- Can assist with immediate cash flow needs.
Cons:
- High risk of penalties.
- Missed opportunities for tax-free growth on the converted amount.
Conclusion
When planning your Roth conversion, consider these ranking strategies for paying taxes. The best choice is to utilize cash savings to maintain your overall retirement growth. Each method has its implications on your long-term financial health. Proper planning and foresight can make a significant difference in how effectively you manage your retirement funds and tax obligations. Always consider consulting with a financial advisor or tax professional to tailor strategies that suit your unique financial situation.
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isn;t there an error at 1:51? the $22 taxable acount money is a negative and not accounted for in the "wealth" at the bottom of the coumn where you show a mysterious 0. In fact, that savings would have also grown if also invested even in a simple interest bearing account, but more likley in stocks.
Thanks for breaking down the Roth conversion tax game! It's wild how every move counts in retirement planning. Speaking of which, have you guys heard about My Digital Money? They're shaking things up, offering a seamless way to dive into crypto within your IRA. Perfect for those looking to stay ahead of the curve and build some real wealth for the future!
So I burn up my cash savings to pay the Roth taxes and then 20 years later this only makes a 2.5% difference in the total ? ($377k vs 386K)
Is it reasonable to re-allocate your tax deferred investments to MINIMIZE gains once the RMDs approach a high tax rate?
I love these videos. Thank you.
I really like how you explain things so clearly. There's another channel where they take forever to get to the point, filling the time with irrelevant fluff, really frustrating.
As semi-retired single filer/standard deduction/67 y/o I make $70k income. If I were to convert $150k, how do I know what amount to withhold for taxes?
Wow there are some really misguided comments here on tax payments. If you are nit a real tax advisor or CPS you all need to stop.
It seems like paying roth conversion tax out of a roth ira is good because $$ from a roth ira is not taxable income. So I can make a bigger conversion inside a lower tax bracket. Am I wrong? I'm 66 had my Roth since 1990s.
Roth conversion before 59 1/2-
Can Roth principle monies be used to pay taxes without penalty?
is there a particular form to use when you pay taxes from a taxable( IRA) account so that it is referenced to the conversion?
What about selling other stocks from a taxable account at a loss and using that to offset the taxes for the conversion? And if you do it late in the year, could the IRS still hit you for penalties?
All these videos about the best way to pay ROTH conversions I have seen, make it seem like it's ALL or NOTHING about the ways to pay for a conversion. Do 100% this way (best) or 100% that way (better) or 100% the other way(ok).
Since I don't have a spare $70,000 in cash to pay federal taxes for the top edge of the 24% tax bracket (for the next 4 years–$280,000+ for federal taxes just sitting in the bank), filing married, I do as much as I can from:
1) cash/cash equivalents FIRST, NOTE that a slight hack here is to maximize federal withholding on "forced" income and to live off the cash/cash equivalents. Since a federal withholding is preferenced over paying quarterly estimated tax payments (as Eric has mentioned in prior videos) in our tax code.
2) then what I can from taxable accounts,
3) then the rest from the Tax-deferred IRA distribution. AGAIN here, paying the federal taxes as a federal withholding is preferential rather than as a quarterly estimated tax.
For my situation, this is the optimum way to it. I think what Eric is saying allows for this optimum strategy for each individual case.
Could you do a video on WHEN (and how) to actually pay the taxes on a Roth conversion? I have heard mixed signals that (for example) if you do a mass conversion in December, that you need to immediately pay the taxes on that conversion, versus just waiting until tax time (Apr next year) and paying the taxes during your normal tax filing. Can you help clarify this?
A point to remember is that the IRS is very particular about how you pay your taxes. If you do a conversion in say, ..October and you try to pay the taxes from any other source except withholding from the conversion, they will access a penalty for failure to make quarterly payments. Withholding is the gold standard for the IRS . You can do a conversion on the last day of December and the IRS will consider it to be done on the previous January 1st. If you have the taxes withheld from the conversion, you are in the clear. But if you just try to pay the tax from another source at the time you do the conversion, you are in trouble. Since the conversion is considered to have been done on the first of January, you are supposed to have done quarterly payments from the start of the year.
Hi Eric, What do you think of paying Roth conversion taxes out of HELOC?
Thank you so much for your response.
I have enough VTI funds to transfer in kind for the Roth conversion , but I will lose the value in dollars because I both these shares at the higher cost than what they are worth now.
Taxes today vs taxes in the future – if you are filing jointly, and one spouse has a shorter expected lifespan, the tax rate in the future will be at the filing single rate.
If one is going to move out of state anyhow then the sale of your home is the best place to use monies to pay for taxes on Roth conversions. Capital gains may be avoided since for MFJ there is 500k exemption.
The 2nd best would be selling of any cars or any other possessions like jewelry. There could be sales tax but it’s lower than capital gains taxes possibly. I say possibly because capital gains is at 0% if income MFJ 80k or so.
Not sure why anybody would put themselves in a position to have too much capital gains tax. Let’s say the “gain” is 25% on stocks. Pulling out 100k proceeds is only 25k gain.
So couple could perform Roth conversion of 80k. Standard deduction 25k. 55k taxable income and could be less with other deductions/exemptions.
Capital gain 25k. So 80k income with gain. So no capital gain and still in 15% bracket.
So only 12k in taxes but the proceeds on sale of stocks was 100k. So couple would still have 88k left over for future Roth conversions.
Only the excess is taxed at 15% also. Still no point in paying. Try staying one bracket lower than your norm from working vs retirement.
Time for some new wall paper behind you.