Reply To: Roth Conversion

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#8345
Kaye Thomas
Moderator

And a happy Thanksgiving to you.

Let’s back up and look at how this strategy is a win for you (or not).

First, you’ve made some nondeductible contributions, creating basis. So long as they remain in the traditional retirement account, investment earnings on these amounts will be deferred but ultimately taxable. Earnings on any portion you move to a Roth account will be permanently free of tax. Because you pay no tax on this portion of your conversion, it is a clear win. It sounds like this is a minor consideration in your case because you have only a small amount of basis, but this is at least a small point in favor of the conversion.

Second, assuming you have funds available from another source to pay the conversion tax, this strategy effectively increases the amount you hold in a tax-favored retirement account. The tax that applies to withdrawals from traditional accounts reduces the amount of usable wealth they provide. A $200,000 account that is really worth just $150,000 if a 25% tax will apply to withdrawals. When you convert $20,000 from that account and pay $5,000 in tax from other sources, you decrease the value of the traditional account by $15,000 (the $20,000 withdrawal minus $5,000 in tax) but increase the value of the Roth account by $20,000. The net effect is a $5,000 increase in tax-favored retirement savings.

The third thing that’s going on is a potential shift in tax rates. Suppose you have to pay 25% on the conversion, but anticipate that if you skip the conversion, you (or your beneficiary) will end up paying a lower rate when these dollars eventually come out of the retirement account. In this case, your conversion makes sense only if the funds remain invested in the account long enough (including the withdrawal period for your beneficiary as well as your lifetime) for the first two benefits to outweigh the disadvantageous shift in tax rates.

On the other hand, if you expect the eventual tax rate to be the same or perhaps even higher, prospects for the conversion are favorable without regard to how long the funds will remain invested.

All these considerations require a crystal ball for any certainty, but understanding how the different factors interact is helpful in making an informed decision.

Now to your specific question. It appears you have an estimate of the tax cost that is usable for planning purposes; that is, for purposes of determining whether to go forward with the conversion, and figuring the amount of estimated tax to pay. You don’t need terribly precise numbers for these purposes. You’ll figure the actual tax when you receive the tax form from your IRA provider.