Why do Investopedia, Vanguard, and Schwab give incorrect advice on how to pay the taxes on Roth conversion?
Posted on December 20, 2024
Investopedia, Vanguard, and Schwab state that you lose after-tax earning power if you pay the taxes on a conversion from your traditional or Roth account. You can find similar advice elsewhere. I assert they are flat-out INCORRECT. When you pay the taxes from your Roth, you are SHIFTING after-tax value from traditional to Roth. You have NO LOSS of future, after-tax spending power. If you pay the taxes from non-IRA accounts, you are doing something different: you are ADDING after-tax value to your retirement accounts that winds up in your Roth.
Details:
• Investopedia: … “you shouldn’t use funds from the [traditional or Roth IRA] account[s] to pay taxes. The best way to pay the tax bill [due on the amount converted] is to use money from a different account – such as from your savings … Paying your taxes from your IRA funds instead of from a separate account will erode your future earning power.”
• Vanguard: [If you convert and pay the taxes from your IRA accounts,] “You’ll lose the chance for that money to compound and grow tax-free in your IRA — which means less money when you need it in retirement.”
• Schwab: “Using IRA funds to pay for the conversion tax could negate the benefits of converting. A better option would be paying the tax with cash on hand.” Schwab provides the same calculator as Fidelity.
• Fidelity’s Roth Conversion Calculator doesn’t give you the choice of paying your taxes from your Roth conversion. The model only lets you pay the taxes from current income or sales of securities in your investment account. The calculator is actually projecting the benefit of tax-free growth from adding to Roth from your taxable account. (I do not find a direct statement from Fidelity that says paying the taxes from retirement accounts lowers future after-tax spending power.)
I assert that these statements are flat out INCORRECT. See summary comparison here.
== Apples-to-Apples SHIFT ==
You pay the taxes from your Roth. You start with $100 in traditional (The after-tax value is $78.) and SHIFT its after-tax value to Roth: you wind up with $78 in your Roth.
I assume a conversion from your traditional IRA will keep you in the 22% tax bracket and that you will pay 22% tax when you finally distribute from your traditional IRA: that’s a good assumption; you really won’t pay less than this. (I ignore state taxes: I assume you pay the same state tax rate on conversion now as you would on distributions from your traditional IRA later.)
Assuming your accounts are invested in the same securities mix, both traditional and Roth grow at the same rate. Let’s say they both double in ten years. You net the same after-tax proceeds at the time of distribution. Paying your taxes from your Roth has NOT eroded ANY future spending power.
Paying the tax is painless. If you are over age 59½, transfer $100 of securities from traditional to Roth. Sell $22 of securities in your Roth and distribute/withhold that $22 for the taxes. You have an added wrinkle to get the $22 for taxes if you are under age 59½: your distribution for taxes must come from your prior Roth contribution basis. More details are in this post.
== Not apples to apples #1 ==
You pay the $22 taxes from your current income. (This is VERY PAINFUL for most.) You are doing more than SHIFTING. You are ADDING $22 of after-tax value to your Roth.
If you are in the 22% marginal tax bracket, you earned ~$28 of current pre-tax income to net the $22 for taxes.
You started with $78 in after tax value in your traditional. You wind up with $100 of after-tax value in your Roth. You have $22 more after-tax value in your IRAs than you did before the conversion. The amount you added equals the tax you paid.
== Not apples to apples #2 ==
You sell securities in your investment account to pay the taxes. (This has some pain for folks under age 59½; see here.) You are ADDING $22 of after-tax value to your Roth.
You previously paid tax, say 22% marginal tax, to get the amount you invested. You paid 15% tax on dividends reinvested and now you’ll pay 15% tax on the long-term gain from higher price/share. For this example, I’ll assume that your long-term capital gain is 40%. Your effective tax rate is 6% (15% times 40%). To net $22, you would sell $23.40.
You did not directly contribute to Roth, but you wind up with $22 more in after-tax value in your Roth – the taxes you paid: you effectively shifted after-tax value in your taxable account to your Roth.
You immediately start to gain after-tax value from tax-free growth in your Roth: you don’t pay tax on dividends reinvested in the Roth, and you won’t pay tax on price appreciation. The initial benefit is small, but it increases over time. In this example, my spreadsheet says Roth nets you >5% more in ten years and >15% more in 25 years. The Fidelity calculator shows similar benefits that increase with time.
== A different amount of apples to apples #3 ==
You sell more from your traditional IRA to pay the taxes. I assume this added amount keeps you in the 22% marginal tax bracket. This is the same result as an apples-to-apples SHIFT, except that you are really converting ~$128 in traditional (after-tax value of $100), and then paying the ~$28 in taxes from your Roth to net $100 in the Roth.
You can distribute for taxes from your traditional without penalty if you over age 59½. But if you are under age 59½, you incur a 10% penalty from withdrawals from your traditional IRA: don’t to do this. See details here.
Conclusion: You can find a number of sources that state you lose after-tax value from converting traditional to Roth unless you pay the taxes from a source other than your traditional or Roth IRA. I assert THIS IS NOT TRUE. You DO NOT LOSE future earning power if you pay the taxes from your IRA.
The simplest, correct way to SHIFT after-tax value from traditional to Roth is to pay the taxes on the conversion amount from your Roth: this is easy to do if you are over age 59½; you have an added wrinkle or constraint if you are under age 59½: you must pay the tax out of your Roth contribution basis – the cumulative amount you contributed to Roth in the past.
If you use current income or sales of securities to pay the tax (painful for most) you are doing something different. You are ADDING after-tax value to your Roth.