What’s the painless way to convert traditional to Roth?
Posted on November 8, 2024
Converting traditional to Roth can be painless: you have NO added tax to pay out of your current income; you’re paying taxes for the conversion from your Roth account. Younger folks in Save and Invest of life don’t have to use any of their take-home pay to pay the taxes due. You don’t face a decision of whether or not to convert to Roth thinking that the taxes mean you can’t spend this year on a terrific family vacation. The steps to convert depend on your age: it’s straightforward if you are over age 59½ at the time of conversion/withdrawal for taxes. You have one added step if you are under age 59½. This post describes the steps.
== $78 Roth = $100 traditional ==
Let’s make sure we agree on this: $78 in Roth has the same after-tax spending power as $100 in traditional.
I’m assuming you were in the 22% marginal tax bracket when you converted to Roth and that you would pay an effective tax rate of 22% when you would sell and distribute from your traditional IRA for your spending: you won’t pay less than 22% effective tax rate on distributions from your traditional IRAs when you are on Medicare and receiving Social Security. See here and here.
(I’ve ignored state taxes in this post. [I pay no tax in PA on distributions from our traditional IRAs.] You can adjust the example. If your state tax is 5% on distributions from traditional IRAs, $73 in Roth is the same as $100 in traditional.)
== Room to convert? ==
There are income limits as to how much you can contribute to your own Roth account in a year. There are no income limits on conversions of traditional to Roth. A conversion will add taxable income, and you want total ordinary income to stay in the 22% marginal bracket. The top of the 22% marginal tax bracket is pretty high. You may have an ability to convert lots of traditional to Roth.
== Summary of Rules on Distributions ==
You can always withdraw your contribution (cost) basis of your Roth without penalty or tax. You report all withdrawals before age 59½. The IRS wants to make sure you are not withdrawing a growth portion from your IRA.
If you are over age 59½, you can withdraw your conversion (cost) basis – the amount you converted – at any time without penalty or tax. You report distributions if you have not held the conversion amount for “Five Years.” Again, the IRS wants to make sure you are not withdrawing a growth portion too early.
See here for more detail on the rules governing distributions from your Roth. See here for tax reporting forms.
== Steps to convert: you are over age 59½ ==
In this example, you are converting $10,000 in your traditional IRA to get $7,800 in your Roth. The $10,000 you are converting keeps you in the 22% marginal bracket. If you are older and on Medicare, I assume this amount does not trip IRMAA – effectively an added tax. For clarity on the steps, I’m assuming this is your first conversion and refer to your new Roth account as your “Roth Conversion account.”
Steps:
1) You transfer shares with $10,000 of value from your traditional IRA to your Roth Conversion account. This is added taxable income and you’ll owe $2,200 in tax.
2) As early as the same day, you sell $2,200 of shares in this account that matches your investment mix.
3) As early as the following day, you distribute/transfer $2,200 to your taxable brokerage account. Your broker will ask how much of this you want to withhold as taxes. Withhold the $2,200.
You now have $7,800 in your Roth Conversion account, and it is invested in the exact same mix as the $10,000 was. Mission accomplished.
(You could accomplish the same by transferring $7,800 from traditional to Roth and withdrawing $2,200 [28% of the $7,800] for taxes directly from your traditional.)
You can follow these steps and convert each year.
== Steps: you are under the age of 59½ ==
There’s one added step for converting from Roth if you are under age 59½. You can’t convert and immediately distribute from your Roth Conversion account for the taxes. You use another Roth account that you already have to pay the taxes due on the conversion.
I assume in this example that you have previously contributed a total of $10,000 to Roth. (It’s value now may be much greater.) I’ll refer to this as your “Contributed Roth” account. This account is the source for taxes due on the conversion.
Steps:
1) You transfer shares with $10,000 of value from your traditional IRA to your Roth Conversion account. This is added taxable income and you’ll owe $2,200 in tax.
2) You sell $2,200 of shares from your Contributed Roth account that matches your investment mix. (You could have done this at any time.)
3) You transfer/distribute the $2,200 to your taxable brokerage account; it’s simplest if you have your broker withhold the $2,200 for taxes.
You have $10,000 in your Roth Conversion account and $2,200 less in your Contributed Roth account. The net change is $7,800, and it is invested in the exact same mix as the $10,000 was. Mission accomplished.
Once you have waited “Five Years”, you are free to withdraw any portion of your cost basis – the $10,000 conversion amount in this example– for any reason. This $10,000 is an added source to pay taxes for other conversions.
Conclusions: Roth conversions should be painless. If you want to convert $100 from traditional IRA, you want to wind up with $78 in Roth. (You’ll at least pay 22% effective tax when retired on the distributions from traditional.) Converting can be painless since you are paying the taxes from your Roth, not from your take-home pay.
When you are over age 59½, you convert and immediately sell securities for taxes from this “Roth Conversion account.” Then distribute and withhold for taxes. Mission accomplished.
When you are under age 59½, you convert, but you sell securities for taxes from your cost basis (sum of all previous contributions) in your “Contributed Roth account.” Then distribute and withhold for taxes. Your Roth Conversion account has the full conversion value and your Contributed Roth account has less by your distribution for taxes. The net effect is the same as above. Mission accomplished.