Roth Conversion Confusion – Taxes Withheld When Under 59 ½
By Andy Ives, CFP®, AIF®
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There is no doubt we have written about this topic in past Slott Report entries. Possibly many times. There is also no doubt that people continue to make this same error, over and over again. Such was the case recently when the Ed Slott team visited with 150-plus financial advisors from across the nation in Boston. While presenting this material to the group, I joked that there is always someone in the crowd who turns ghost white upon hearing what I say. Sure enough, at the next break, an advisor approached me, hat in hand, and said, “I am the person who turned ghost white while you were speaking.” Why did all the blood rush from his face? Because he realized he had repeatedly made the same mistake with many of his clients, and those Roth-conversion-error chickens were about to come home to roost.
When a person does a Roth conversion, that transaction will be taxable, and there is no way to reverse the decision to convert. You cannot un-ring that bell or put the converted Roth toothpaste back into the traditional IRA toothpaste tube. What’s done is done. We could quibble over the pro-rata rule and how much of the conversion is taxable, but that is not the point of this article. Assume no after-dollars exist and this is a 100% taxable matter.
It is our advice to pay the taxes due with other, non-qualified assets – like money from your checking account. This way the entire amount of the conversion moves into the Roth IRA, and the entire amount begins to grow tax-free. However, not everyone has extra cash on hand to pay the conversion tax. So, another option is to pay all or part of the tax from the IRA – via withholding. For example, if I convert $100,000, the entire $100,000 is taxable. If I elect to have 20% withheld for taxes, only $80,000 moves into my Roth IRA. When tax time arrives, I will have already sent $20,000 to the IRS. Understandably, this softens the tax blow come April.
In and of itself, the above is not a problem. The trouble occurs when taxes are withheld on a Roth conversion for a person who is under 59 ½ years old. This is why the advisor in Boston turned ghost white. He realized he had taxes withheld for many of his younger clients. While his heart was in the right place – to help people transition from a “forever taxed” account to a “never taxed” account - his technique was terribly flawed.
What is the issue? Taxes withheld on a Roth conversion are not converted. Technically, the withheld dollars are a standard withdrawal that is sent to the IRS. For anyone under 59 ½, an early withdrawal is subject to a 10% penalty (assuming no other exception applies).
Example: John is 35 years old. He has a traditional IRA worth $100,000. John discussed the possibility of a Roth conversion with his advisor, but was concerned he did not have the extra funds available to cover the taxes due on the conversion. John’s advisor suggests having the taxes withheld from the IRA. This is bad advice, but John is unaware of the consequences. John converts the entire $100,000 and has $20,000 withheld for taxes. This $20,000 never gets converted. It is an early withdrawal, and John is hit with a 10% penalty of $2,000. John is furious. He contacts his advisor, but the call goes to voicemail. Ironically, John’s advisor is sitting in the crowd at an Ed Slott advisor training program. He is simultaneously turning ghost white as the speaker implores the audience to never have taxes withheld on a Roth conversion for anyone under 59 ½, for all the reasons discussed above.
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