Roth IRAs are amazing tax saving tools. Roth IRAs allow your investments to grow tax-free. Even though there is no deduction for contributions, a Roth IRA provides the dual benefits of tax-free accumulation and tax-free distributions after age 59 1/2. The long-term benefits can be significant. We suggest you fund your Roth IRA even when you can’t afford it and that you use taxable savings as your seed money.
In addition to making Roth contributions, we frequently recommend moving assets from your traditional IRA into a Roth IRA in what is called a Roth conversion. Roth conversions can avoid future Required Minimum Distributions (RMDs), enhance the value of your estate, and smooth your tax burden across several years.
Roth conversions are almost always a good idea and converting something is almost always better than doing nothing. There is a “best conversion” and we can do our best to predict which plan it is, but even the “worst conversion” plan can save hundreds of thousands or even millions of after-tax value over doing nothing.
However, even after all the mathematics of predicting a best conversion plan, when April 15 finally comes, paying for your conversion hurts. It almost always does.
France’s Louis XIV’s finance minister Colbert is quoted as saying, “The art of taxation consists of so plucking the goose as to obtain the largest possible amount of feathers with the smallest amount of hissing.” Although this quote comes from France, it may as well be the IRS’s mission statement.
As Mises Institute reports quoting Murray Rothbard:
Before World War II, when income tax rates were far lower than now, there was no withholding system; everyone paid his annual bill in one lump sum, on March 15. It is obvious that under this system, the Internal Revenue Service could never hope to extract the entire annual sum, at current confiscatory rates, from the mass of the working population. The whole ghastly system would have happily broken down long before this. Only the Friedmanite withholding tax has permitted the government to use every employer as an unpaid tax collector, extracting the tax quietly and silently from each paycheck. In many ways, we have Milton Friedman to thank for the present monster Leviathan State in America.
Most of your tax bill is silently sent away. If your withholding is known to be insufficient, then you are expected to pay estimated taxes in four installments, making each one emotionally more manageable. By the time April 15 rolls around, you only pay a small percentage of your total bill. The price tag on your tax return is a finger, compared to the whole arm you lost over the course of the year.
Roth conversions, however, should not have withholding. You are allowed to withhold, but you should not. Distributions from your IRA, be they for withholding, conversion, or withdrawals, are all taxed on your return. Furthermore, it is hard to get money into a retirement account. All retirement account contributions are guided by strict limits which only allow you to save so much in these preferred accounts. Best to keep more assets for the conversion and pay the bill from your taxable. But that means writing a higher check at tax time.
It almost doesn’t matter what the numbers are. Imagine the plan is to convert $20,000 in the 25% bracket. It looks really great on paper and you completely agree. However, when tax time comes around, you have to write a check for $6,500. Imagine last year you wrote a check for only $1,000. The additional $5,500 comes from your small wages and dividend increases and your Roth conversion. Now, you have to go to your taxable account and sell securities to generate enough cash to pay the bill. Then, it is an ordeal to send the check in or debit the money. It makes you grumpy and sad. You are tempted to wish the conversion away even though it is exactly what the plan was. A Roth conversion of $20,000 in the 25% is a tax of around $5,000. It hurts, but it is smart.
We have loss aversion. We like keeping our feathers and don’t want to be plucked by the IRS. Unfortunately, we are going to get plucked one way or another. The only financial advice for these moments is to ignore your emotions.
Roth conversions are the jogging of the financial world. You hate running because it makes your muscles hurt until you see the benefits. After years of investment in a painful hobby, you wake up one day and realize that you have an elevated mood, a stronger body, and are an avid jogger. Keep running.
Roth conversions pay off. Repeat it
to yourself now. Repeat it to yourself at tax time. Roth conversions pay off.
Don’t delay Roth conversions out of fear. Waiting just one year means that you lose a portion of the growth in your traditional IRA to income taxes later. And after age 70, waiting just one year means that you lose another year of RMDs to your taxable account.
Having a tax rate of 20.75% on your account puts a drag on your portfolio returns of 1.4525%. Over 30 years, that means a portfolio just 66.36% of what it could have been in a Roth account.
Be brave. Fund your Roth. Convert your IRA. Pay your tax bill. Your future self will thank you.
Photo by Taylor Kiser on Unsplash