Prepaying income tax on a retirement account might be a good idea. Or it could be a really bad idea. Read this before pulling the trigger.
By William Baldwin, Senior Contributor
Your financial advisor may be all fired up about prepaying tax on an IRA, converting it into a totally tax-free Roth IRA. Is this a great idea? Sometimes. Not always.
The recent election of a tax-cutter to the White House should have diminished the fervor of Roth fans. One of their arguments was that low tax rates passed in 2017 under then President Trump are scheduled to expire at the end of 2025, so you should jump on an opportunity to prepay. Now, there’s a good chance the low rates will be extended. There’s less reason to hurry.
The power shift in Washington to President Trump and Republican control of both the Senate and House is just one thing that should make you re-examine a Roth conversion plan. A conversion cannot be undone. Before proceeding, see if any of these 11 reasons for not Rothifying applies to you.
1. You’re using some of the IRA to cover the tax bill.
This defeats the purpose of converting.
Example: You are and will be in the 30% bracket (federal and state combined). Converting now, while extracting $30,000 for the taxes, leaves $70,000 in the account. Assume the portfolio doubles by the time you take the money out. You now have $140,000 of spending money. But with no conversion, your $100,000 would have doubled to $200,000 and after taxes you’d have the same $140,000.
What you have gained by converting: nothing. Why bother? Why expose yourself to the downsides of converting (see #2 through #11 below)?
There are hypothetical situations in which you could come out ahead while using $30,000 from the account to pay tax, but they are not worth the mental effort.
For comparison, see what happens if you do use outside money to cover the tax bill. You’re taking $30,000 you have sitting around, plus $100,000 in a pretax retirement shelter, and turning all that into a $100,000 aftertax shelter. It doubles to $200,000. In effect, your $30,000 grows, under the shelter, to $60,000 in spending money. That is, you have used the conversion to shelter $30,000 that was previously exposed to annual tax damage.
That trick, that sheltering of the $30,000, is the essence of what makes a Roth conversion smart, at least for the majority of taxpayers who aren’t taking advantage of a temporarily low bracket.
Rule of thumb: If you can’t cover the tax bill from outside the account, and if you don’t have a dip in your tax rate, don’t convert.
2. Your estimated tax payments were low.
Your withholding plus quarterly estimated taxes for this year may not have allowed for any conversion. Plunge in now, jacking up your income by $100,000 (in our example), and you might owe a penalty. Take a look before proceeding with a conversion.
If there is going to be an underpayment penalty, it might still make sense to convert. But maybe it’s not worth doing all the arithmetic to find out. Instead, give yourself some leeway for a conversion next year.
Set up next year’s quarterly estimated taxes so that your payments equal 110% of this year’s tax total. That safe harbor means you can have a spike in income of any size without incurring an underpayment penalty. The 110% coverage, of course, affects only the timing of tax bills. You still owe the $30,000, but you can pay it in April of the following year.
3. You make donations.
Once you turn 70-1/2, you can send money in a pretax IRA directly to a charity, bypassing your tax return. Maximum: $105,000 per calendar year.
For this reason you should leave, unconverted, a sum equal to your likely donations for 20 years. (Let’s assume you live to 90.) If, on turning 83, you find yourself unable to continue your generosity, no great harm done in failing to convert. You’ll be taking the money out for yourself and paying tax at that time rather than today. You’d be missing out only on the shelter enhancement described above in #1.
4. You’re planning a charitable bequest.
Assets left in an unconverted IRA are ideal for covering a bequest to a charity. The charity inherits with no obligation to pay the income tax you never paid on that money. Take this up with your estate planner.
Let’s say you have $2 million, half in a pretax IRA, the rest not. You want to leave $1 million to granddaughter Sally and anything remaining to the Red Cross. It might make sense to name Sally the primary beneficiary of the IRA and the Red Cross the contingent beneficiary, while directing your executor to let Sally select which assets she takes. Depending on what’s happened to your portfolio when you die, Sally will probably disclaim most or all of the IRA in order to acquire assets that don’t have an income tax liability attached to them.
5. Your IRA beneficiaries are in a low tax bracket.
Say you name six grandchildren as beneficiaries, and they’ll all starving artists. They can spread their withdrawals over ten years, and pay income tax from an inherited pretax IRA at lower rates than you would pay today on a conversion. Don’t convert that money.
6. You’re moving.
It would be foolish to convert when you’re in California, and pay California income tax on the money, if you’re planning to move to Texas.
7. You might have a gap year.
Let’s suppose it will take you seven months to get a new job if you get axed. That low-earnings, low-bracket year would be the better time to do a conversion. What’s the chance of such misfortune? How secure is your employment? If you work for a necktie manufacturer, you probably should hold off on a conversion for now.
8. You’re near the top of a bracket.
It rarely makes sense to convert so much that you kick your taxable income into the next bracket. Keep an eye on the break points.
The 24% federal rate, for example, applies this year to married couples with adjusted gross incomes, roughly speaking, between $230,000 and $412,000 (exact amounts depend on your circumstances). Cut these numbers in half for singles.
Taxpayers over 63 also have to beware of Medicare premium surcharges. These aren’t as consequential as tax brackets, but they do run to thousands of dollars. For a couple, there are AGI dividing lines at $258,000, at $356,000 and at various other places. The complicated formulas are detailed here.
9. You might need a nursing home.
We’ll assume here that you are (a) fairly well off and (b) intelligent enough to have never bought a long-term care policy. You have a pile of money you probably won’t need and will probably be left to heirs. But you would use it for nursing care. That amount should be left unconverted.
Why? If you do get carted off with Alzheimer’s, your guardian can marry a taxable withdrawal (or conversion) from the IRA to a tax deduction for medical expenses.
10. You collect dividends.
A 3.8% surtax applies to the lesser of two numbers: (a) the amount of investment income like dividends, interest and capital gains; (b) the amount by which adjusted gross income exceeds $250,000 (joint return) or $200,000 (single).
“Investment income” is defined to exclude payouts and conversions from IRAs. But the formula is constructed in such a way that some conversions get hit indirectly.
Suppose you have $240,000 of adjusted gross on a joint return, of which $40,000 is dividends. Now you throw in a $50,000 conversion. That lofts all your dividends into surtax category. In effect, four-fifths of your conversion is subject to an extra 3.8% rate.
Calculate your non-investment income, which includes salary, pension and mandatory IRA withdrawals beginning at age 73. If this quantity is above the $250,000 or $200,000 threshold you can ignore the 3.8% surtax. If it’s lower you have to do some calculations before deciding how much to convert.
11. You might need the money soon.
Withdrawals within five years of conversion can expose you to a tax or penalty. The complicated rules are set out in a diagram on page 32 of IRS Publication 590-B.
One of the kinkier rules on Roth accounts makes taxability hinge on whether you have had any Roth account of any size in place for at least five years. This particular rule means that if you don’t already have a Roth account you should set one up tomorrow, if only with a token sum in it.