Retirement Answers

Jacob: 00:01

Now, Roth conversions are not always helpful for everyone, but if you are someone who has a large portion of your retirement savings in that tax deferred IRA or four zero one ks, you should consider evaluating to see if Roth conversions might be right for you. Welcome to Retirement Answers, a podcast built to answer your most pressing retirement questions. If you're someone who's either thinking about retirement or already in retirement, well, you're in the right place. Hey there, my name is Jacob Duke, and each week I'll be walking through different tips and strategies to help you succeed in retirement. So let's go ahead and get started with today's show.

Jacob: 00:44

Hey everybody, welcome back to Retirement Answers. As always, my name is Jacob Duke and hope you're having a great week. This week, I wanted to talk about the topic of paying your taxes on Roth conversions because most of us have heard about Roth conversions and how they can be really helpful in lowering your taxes throughout retirement. But a common question that comes up is, well, how do I actually pay the taxes on those conversions? And this is an important step to have figured out because if done incorrectly, you could end up with late payment penalties.

Jacob: 01:12

So today I wanted to share with you everything that you need to know about paying taxes on your Roth conversion so that you get the most benefit out of this really important tax strategy. But before we get started, if you're enjoying the show, would love it if you could give me a rating and review. If you're listening on Spotify or Apple Podcast, Those reviews help more people find the show and it would be greatly appreciated. Thanks for taking the time to do that. So let's go ahead and get started with today's episode.

Jacob: 01:36

Alright, whenever it comes to planning for retirement, we often hear about how we should be planning for taxes and implementing different strategies that help lower your tax bill throughout your retirement or the rest of your life. And Roth conversions are often brought up as a way to do that. When doing a Roth conversion, you are electing to pay that tax now on some of your tax deferred savings to move that money into a Roth IRA. So moving money from a pre tax account to a post tax account, and when you do this, you have to pay your income taxes on the money that you're moving from the IRA to the Roth IRA. Now, Roth conversions are not always helpful for everyone, but if you are someone who has a large portion of your retirement savings in that tax deferred IRA or four zero one ks, you should consider evaluating to see if Roth conversions might be right for you.

Jacob: 02:17

And once you or your financial planner have decided that Roth conversions are a good fit for you, one of the biggest questions that comes up is how do we pay the taxes on those conversions? So that's what we're gonna talk about today. So there's two primary ways that you can pay the taxes on your Roth conversions. I'm gonna go ahead and walk through each of these ways, right now, and then I'm gonna give you my thoughts on perhaps the best way to pay the taxes on those conversions. So the first way to pay taxes on your conversions is to have those taxes withheld from the amount that you're converting.

Jacob: 02:45

So for an example, let's say that you're doing a $100,000 conversion and you're withholding taxes from the conversion amount. You will choose how much to withhold based on your expected tax rate. So you really need to know what your total income is gonna be for the year before you can actually start thinking about how much you need to be withholding. And knowing your income will help you know what your marginal tax rate will be on the amount that you're gonna be converting at both the federal and state level. So once you know what your tax rate will be, you can have that amount withheld from your conversion.

Jacob: 03:14

So back to our $100,000 conversion example, if your federal tax rate is is gonna be 22% and your state rate is gonna be 5%, let's say, not everybody has a state income tax, but let's just assume that it's 5%. You will be withholding a total of 27% or $27,000 on that $100,000 conversion. So you're taking $100,000 out of your IRA, but only 73,000 is actually going into your Roth IRA. Now it's important to note that when you're withholding the taxes from your conversion, your age could be a very important factor. So do you remember the distribution rules for taxes and penalties on IRAs?

Jacob: 03:51

Well, you'll be taxed anytime that you take a distribution from your IRA, but if you take a distribution before 59.5, you will owe an additional 10% penalty because you would be taking that early. So that 10% penalty is just added to the taxes you would otherwise owe. Now, what's interesting about withholding taxes from a conversion amount is that tax withholdings are actually considered a distribution out of the IRA. So if you're under age 59.5, you would have an additional 10% penalty on the amount of taxes that you would be withholding. So let's go ahead and walk through another example really quickly, but first I wanted to emphasize that the entire conversion amount is not subject to that 10% early withdrawal penalty, only the tax withholding is.

Jacob: 04:35

So think of it this way, when you're doing a Roth conversion, you are moving money from a traditional IRA to a Roth IRA. So has that money ever left an IRA account? No, it's still in an IRA, it just moved from one to another. Because of this, it's not really considered an IRA distribution, thus your age doesn't matter. So I repeat, your age does not matter whenever you're doing a Roth conversion.

Jacob: 04:55

You can do them at any point without penalty. But if we think about the tax withholding, we are taking it from a traditional IRA, but it isn't going into the Roth IRA. That money is being sent to the IRS on your behalf. Since this money is not staying in either a traditional IRA or a Roth IRA, it is considered a distribution, and that's where the penalty on the tax amount could be an issue for you when you do those conversions under 59.5. Okay.

Jacob: 05:20

So back to our example, the tax withholding on the $100,000 conversion was $27,000 That $27,000 is considered a distribution from the IRA. So you will owe an additional tax on it of 10% if you do that before 59.5. So that means you would have an additional $2,700 that you would have to pay on top of the taxes you already owe for that $27,000 withholding. So I know that there's a lot there, but just take a second to kind of wrap your mind around that. If you're under age 59.5 and you do a withholding from your Roth conversion amount, you could have that 10% penalty on top of the taxes you're already withholding.

Jacob: 05:57

Okay, so let's go ahead and talk through the second way that you can pay the taxes on those Roth conversions. And this one's a little bit more straightforward and it's that you can simply pay those taxes with cash that you have on hand. So if you're doing a $100,000 conversion, that means all $100,000 would be moved from your traditional IRA to your Roth IRA. And you would pay that $27,000 taxes, like we mentioned before, out of cash that you have on hand, whether that be at the bank or in your brokerage account, doesn't really matter. It's just not being withheld from the conversion amount.

Jacob: 06:27

And whenever you pay the taxes on a conversion with cash, I would suggest going ahead and prepaying the taxes so that you aren't assessed any late payment penalties. So you can either pay those in full at the time of the conversion, or you can make estimated quarterly payments. So paying the taxes with cash on hand probably the easier and more straightforward way to do this because you don't have to worry about your age being 59.5 or not. You don't to worry about not having all of your money go from traditional IRA to Roth, which means some of it's not gonna be invested. So the easiest and perhaps the best way maybe to do a Roth conversion and pay the taxes on it is to pay that money out of cash.

Jacob: 07:01

So that might be one of the questions you have. Well, what's the best way to pay those taxes? Well, in almost every situation, it's better to pay the taxes on your Roth conversions with cash that you have on hand rather than having those taxes withheld from your IRA. This is because if you can move the full conversion amount from your traditional IRA to your Roth IRA, you can immediately begin to see the benefits of that tax free growth in your Roth account. Thinking back to our $100,000 conversion example, and we're withholding $27,000 in taxes, it is better to have that $27,000 in your Roth IRA growing tax free than to have that $27,000 still in cash or in your taxable account.

Jacob: 07:39

The benefits aren't immediate because your net worth is still technically the same, whether or not you pay the tax from cash or have it withheld from your conversion amount, but the long term benefit of having that $27,000 growing in your Roth account being after tax money will boost number one, your after tax savings, but also help build out that tax diversification I often talk about. On the flip side, if you had those taxes withheld from the conversion amount, you have a hole to dig out of before you can actually see the benefits in that Roth IRA. Because you're gonna have to make up that $27,000 tax withholding before you actually have the same amount of money, 100,000 in your Roth as you did in your traditional IRA. So that's really important to remember if you're actually having the taxes withheld out of your conversion amount, you're digging yourself a little bit of a hole that you've got to climb out of before you begin to break even again. And the second reason to pay the taxes on your conversions from cash or from a taxable account, rather than having them withheld is if you plan on doing these before age 59.5, like I mentioned earlier.

Jacob: 08:36

I see this penalty catch a lot of people off guard because they're unaware of how the tax rules work and they don't think of a tax withholding as a distribution. And the penalty ends up eating to those benefits of doing the Roth conversion in the first place. So paying the taxes with cash is gonna end up giving you the best results from your conversions. And honestly, gives me the opportunity to remind you that building up cash is very important before you enter into retirement, whether that be cash in the bank or after tax assets that you have in your brokerage account. If you don't have any cash available to pay the taxes with, you're always gonna be forced to have those taxes withheld from your IRA whenever you're doing a conversion.

Jacob: 09:11

So creating flexibility for yourself in retirement is an important part of making the most of your money. It's important to create a really thoughtful plan for where you save throughout your career, and as you get closer to retirement, it becomes that much more important. So when deciding on how to pay taxes on your Roth conversions, I definitely encourage you to consult with your trusted advisor, because there's just so many moving parts with Roth conversions and it can be really confusing and making sure your taxes are paid correctly, that way you don't have any penalties and anything like that, go ahead and talk with your trusted advisor, make sure you're doing that correctly. But these are the two primary different ways that you can pay taxes on a conversion. You can either have it withheld or you can pay that with cash.

Jacob: 09:48

And in my opinion, paying those Roth conversions out of cash that you have on hand is the most optimal way to pay the taxes and ultimately begin seeing the benefits that you have in your Roth IRA. So I hope this is helpful as you continue to think about Roth conversions, how to pay those taxes. With that, let's go ahead and answer this week's question of the week. Alright, this week's question reads, hey Jacob, I know that IRAs have an annual contribution limit and since I'm over 50, I can contribute $7,500 this year in 2023. But I was wondering if I could contribute $7,500 to a traditional IRA and then also $7,500 to a Roth IRA.

Jacob: 10:24

I have some extra cash laying around and I wanna make sure that I have it invested. Thanks for the podcast. It's been really helpful as I plan out my transition into retirement. First of all, thanks so much the question and I really appreciate you listening and I'm really glad to hear that it's been helpful for you, as you kind of think about retirement and put your plans together. So, the question you just asked, whether or not you can contribute $7,500 or just max out a Roth and a traditional IRA in the same year is a common question that I get.

Jacob: 10:49

And the short answer is no, you cannot. An IRA is an IRA and it's an IRA. So whether it's a traditional IRA or a Roth IRA, they both have the same limit of $7,500 per year or $6,500 if you're under age 50. And what's really important to understand here is that the annual contribution maximum is a combined maximum. So that means you could do like $3,000 to a traditional IRA if you wanted, and then also $4,500 to a Roth or any sort of combination to reach the $7,500 maximum in your case being over age 50, but it doesn't really matter how you get there.

Jacob: 11:23

Just know that overall in across all of your IRAs, whether that be Roth or traditional, you can have 13 different accounts, but the maximum contribution for all those combined is still gonna be that $7,500 per year. So think of it as like if you had multiple four zero one k's for multiple jobs, maybe work two jobs for example, your annual limit for contributing to a four zero one k is 22,500 if you're under age 50. Doesn't That mean you can do 22,500 to one and then 22,500 to another, those four zero one k contribution limits combine as well. So think of it as the account type has a limit, not each individual account has a limit. So you're not able to double dip on your IRA contributions.

Jacob: 12:01

The $7,500 limit is for all IRA contributions combined. So thanks for the question and thanks for listening to the show. I really hope this has been helpful and I look forward to talking with you again really soon. Hey, it's Jacob again and I wanted to extend a quick offer to you. If you have a question and you would like to have it answered here on the show, please email me at jacobretirementanswers dot net and I'd love to answer that question for you right here on the show.

Jacob: 12:28

Also, wanted to remind you that nothing discussed in today's episode is meant to be financial, legal or tax advice. Retirement Answers is for educational purposes only. Thanks for tuning into this week's episode. I look forward to talking with you again next week.