Do *Not* Withhold Taxes from Your Roth Conversions

A reader wrote in to me last week explaining his DIY retirement plan.

His plan involved Roth conversions. No problem so far.

Roth conversions create taxes. Indeed, unavoidable.

And his plan was to pay those taxes via withholding dollars from the Roth conversion.

Hold up!

Withholding and Roth Conversions

Withholding tax is money that an employer (or other payer) deducts from your income and sends directly to the IRS. It’s a preemptive payment toward your annual income tax. Most of us are familiar with withholding in our normal W2 paychecks.

In the case of Roth conversions, withholding is money that your custodian (Schwab, Fidelity, etc.) deducts from the conversion amount and sends directly to the IRS.

Rather than 100% of your dollars ending up in your Roth account, you get 100% minus your tax rate.

By electing this withholding choice, you are using qualified Roth IRA dollars to pay your taxes. That could probably be the end of the article right there.

Would you rather pay your taxes using regular bank dollars? Or using Roth IRA dollars? It’s a clear choice.

But numbers will help us clarify further.

Two Simple Roth Conversion Scenarios

Let’s say you convert $10,000 in the 12% Federal bracket. You also have a normal bank account with $50,000 in it.

Scenario 1: You withhold your taxes from the conversion. 

You convert the $10,000. You withhold $1200. Only $8800 ends up in Roth. 

You still have $50,000 in the bank. 

Scenario 2: You use bank dollars to pay the tax bill. 

You convert the $10,000. All $10,000 ends up in your Roth. 

You now have $48,800 in the bank. 

The Difference is Clear

There’s a $1200 difference between the scenarios. 

That $1200 either ends up in your bank account or in your Roth IRA.

I know which one I’d prefer, and it’s not even close. It’s the Roth!

In fact, you could easily argue that withholding taxes from your Roth conversion is so inefficient that it’s actually worse than never having done the conversion in the first place.

Are you 59 Yet? Because It Gets Worse…

If you’re younger than 59.5, then today’s idea is even worse for you.

Early withdrawals from IRAs and 401ks typically come with a 10% penalty tax.

Roth conversions are not considered an early withdrawal. Roth conversions are safe.

BUT…if you withhold taxes from your Roth conversion, then that withheld portion is not considered a conversion. It’s considered a distribution. An early distribution. Subject to a 10% penalty.

You owe extra taxes on the money you withheld to pay taxes. It’s taxes all the way down.

You do not want to do this.

What To Do Instead

When you make a Roth conversion, you’ll want to pay the tax bill using non-qualified dollars, such as those found in your bank account or taxable brokerage account. Though ideally, you aren’t realizing capital gains in your taxable account to pay your Roth conversion bill!

You’ll want to make sure that you’re safe-harbored (which is its own complicated explanation)…

Or that you make an intra-year quarterly estimated tax payment to cover your conversion.

Just don’t withhold taxes from your Roth conversions. Please.

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