When we work with our clients on executing their Roth conversion strategy, a common question we discuss is: “How much do you want withheld in taxes?” Since we custody our client investment assets with Schwab, Schwab offers the option to select the percentage of an IRA withdrawal that is remitted for taxes. Once the selection is made, Schwab remits the appropriate amount to the IRS, and it is reflected on Block 4 of the Form 1099-R that Schwab issues at the end of the year.
But this selection does present 2 (or really more) ways to think about how you pay the additional taxes on your Roth conversions:
Select an appropriate percentage (commensurate with your marginal tax bracket) that is withheld.
Withhold nothing, and pay the taxes with outside money.
There is also a third option, which is to find some sort of middle ground—select some withholding, but with the understanding that you might need to pay the difference with outside cash.
This article will help illuminate the differences in these two approaches, and discuss why you may want to be deliberate when selecting what is appropriate for you.
Note: This article only discusses federal income tax withholding, as Lawrence Financial Planning is an investment advisory firm based in Tampa, Florida and the majority of our clients do not have to worry about state income taxes. If you are a reader who is unfortunate enough to live in a state that charges an income tax, you may have to do a little extra work to account for state taxes. Or, you should at least have the discussion with your investment advisor or tax professional so they can do the work for you.
Roth Conversion Option One: Pay As You Go
For many people, this is a default option. When we illustrate a tax projection for our clients, the tax projection shows their marginal tax bracket. This makes it relatively straightforward to plug into the conversion. If the tax projection is done properly, there’s little impact to the amount that person will owe (or expect as a refund) at tax time.
For example, if a client wants to do a $30,000 Roth conversion and is in the 22% tax bracket, they would (or we would, on their behalf), select 22% withholding when doing the conversion. This allows Schwab to:
Withdraw $30,000 from the IRA
Withhold $6,600, which is then remitted to the IRS as a tax payment
Transfer $23,400 into the Roth IRA.
While many people do appreciate being able to do Roth conversions without much impact to their cash flow, the trade-off is that less money makes it into the Roth account. To avoid this, you can look at option two.
Roth Conversion Option Two: Pay Taxes with Outside Money
For people who are more concerned about tax efficiency than cash flow, this might be a palatable option. Using the above example, a client would simply select 0% withholding when transferring from their IRA. This would ensure that 100% of the $30,000 IRA withdrawal lands in the Roth account.
Of course, this assumes that the $6,600 in additional taxes is paid in some other fashion. This doesn’t mean that you have to have $6,600 sitting in a bank account for the sole purpose of paying your tax bill. Below are a couple of ideas worth considering:
Your tax projection shows that you are on track for a huge refund. If your tax projection shows a huge refund looming, you may be able to do a Roth conversion with little or no discernable impact to your cash flow. This is something we often recommend to clients who might have cash flow concerns.
Increase tax withholdings in your paycheck. This could be an option for someone who might have maxed out all of their tax-preferred savings options, and is looking for the answer to the question: “Where do I put my money next?” While the increased tax withholdings might not seem like investing per se, they another way to keep as much in your Roth as possible while mitigating the risk of underwithholding penalties.
Use a maturing bond or CD. One of the reasons we have bond ladders for our clients is to have cash available for needs as they arise.
Harvest some capital losses. If we’re making investment recommendations to clients, we always point out the tax implications of that sale. While taxes don’t dictate what our big picture approach looks like, we may factor capital losses (or tax-loss harvesting) into the trades. Capital losses can lower taxable income (by up to $3,000 per year), and the cash generated can be set aside for taxes.
Sell some appreciated investments as part of your rebalancing. While the previous approach is known as tax-loss harvesting, this is tax-gain harvesting. It is particularly attractive for someone in the 12% marginal tax bracket (where the tax rate on long term capital gains is 0%). We often do the following for clients:
Run a tax projection for the current year to ensure the client is projected to remain within the 12% tax bracket. Included in the projection is an estimate of how much of a capital gain they might realize while remaining in the 12% tax bracket.
Sell an appreciated investment at a gain after having estimated a 0% capital gain (assuming they’re in the 12% tax bracket).
Repurchase that same investment. Or a different one if we’re rebalancing. Since this is a taxable gain, there is no wash sale rule (where you have to wait 31 days in between selling one investment and repurchasing it or a substantially similar security).
Or you might not need to generate any outside cash. If that’s the case, then it might make sense to keep as much of your investments inside your Roth accounts as possible, and pay your taxes with outside cash. Regardless of how you generate this cash, you’ll want to ensure that you are having enough money remitted to the IRS throughout the year to avoid underwithholding penalties. Most people do this by:
Having taxes withheld from their paychecks or IRA withdrawals, or
Sending estimated taxes directly to the IRS periodically throughout the year.
Usually, your tax professional can help you calculate estimated taxes. Many of them automatically do this by generating estimated tax payment vouchers (using Form 1040-ES) when they prepare your previous year’s tax return. We also do this for our clients, particularly when we do our tax planning appointments during the year.
There is no right way or wrong way to pay your taxes when doing Roth conversions. Paying taxes from the IRA withdrawal allows you to do conversions while minimizing impact to your cash flow. If cash flow is not a problem, then paying your taxes with outside money allows you to maximize the amount of money that ends up in your Roth account. Of course, there are any number of ‘in-between’ options for people who might not be committed to either extreme.
Roth conversions shouldn’t be done in a vacuum. They should be done as part of a deliberate Roth conversion strategy, either one that you’ve created on your own or that you’ve created in consultation with your tax professional or investment advisor. If you’re having a hard time coming up with your own strategy and your advisors aren’t able to help you, contact us. We would be more than happy to see how we might be of service to you.