Importance of Timing a Roth IRA Conversion

December 12, 2014  | By Kevin Smith

Conventional wisdom holds that if you convert a traditional IRA to a Roth IRA, you should never pay the conversion taxes from IRA assets. The reason is that you’ll be depleting IRA assets that might otherwise be available to grow on a tax-deferred basis. The withdrawal from a traditional IRA to pay the conversion taxes is also a taxable distribution, generating an additional tax liability, requiring an additional withdrawal, and so on–plus you’ll generally pay a 10% penalty if you’re not yet 59½.

It’s also conventional wisdom that converting a traditional IRA to a Roth IRA is tax neutral so long as income tax rates remain the same at the time of conversion and after retirement.

Conventional wisdom isn’t always right

But there’s one scenario where conventional wisdom may not apply. This is best explained with an example.1 Let’s assume the following:

1. You’ll be 59½ or older as of January 1, 2015, and you’ve had a Roth IRA for at least five years. So you’ll be eligible for tax-free and penalty-free qualified distributions from your Roth IRA in 2015.

2. You’ve decided that it’s appropriate for you to have more retirement assets in a Roth IRA.

3. You own a stock in your traditional IRA that you anticipate could be a candidate for higher-than-average gains. For example, let’s assume you own 10,000 shares of Acme Pharmaceuticals, a highly speculative biotech that has a drug pending before the FDA. The shares are currently trading at $10. After diligent research, you’ve determined that the Acme stock could climb to as much as $50 if the drug is approved by the FDA, but it is equally likely to drop to $1 if not approved. The FDA deadline for approval is October 1, 2015. (For simplicity, we’ll assume the Acme stock is the only asset in your traditional IRA and that you are converting the entire IRA.)

4. You want to convert your traditional IRA to a Roth in 2015, before the potential appreciation in Acme stock, but you don’t have any cash available to pay the conversion tax, or you simply don’t want to pay the conversion tax from other (non-IRA) assets.

Now let’s further assume that Acme’s drug does receive FDA approval on October 1, 2015, and the stock does in fact jump from $10 to $50.

Result if you do not convert

If you did not convert your traditional IRA to a Roth IRA, your traditional IRA would now hold 10,000 shares of Acme stock worth $500,000. Again, for simplicity, let’s assume you sell the stock, your account now holds the $500,000 cash proceeds, and you make no further trades or contributions to the account. Assuming you earn 6% until your retirement in 10 years, your account would grow to approximately $895,000. Assuming a 28% federal income tax rate, the after-tax value of your account would be $644,705 at retirement.

Result if you do convert

Now let’s assume you did convert your traditional IRA to a Roth IRA before October 1, 2015. The stock was worth $100,000 at the time of conversion, and assuming a 28% tax rate, the federal income tax is $28,000, due when you file your 2015 tax return. On October 1, when the drug is approved, the value of the shares increases to $500,000. Again, for simplicity, let’s assume you sell the stock, your account now holds the $500,000 cash proceeds, and you make no further trades or contributions to the Roth IRA.

On October 1 you also receive a tax-free $28,000 qualified distribution from the Roth IRA to pay the conversion tax (although technically you wouldn’t need to actually pay that tax until April 15, 2016).2 Now your Roth IRA balance is $472,000. Assuming the same 6% earnings rate, after 10 years your IRA would have grown to approximately $845,000–about $200,000 more than if you had not converted–even though tax rates have remained constant and you’ve paid the conversion tax from IRA assets.

There’s no magic to this. You’re simply paying–from the Roth IRA–conversion taxes on the stock before the appreciation, instead of paying taxes on the fully appreciated value of the stock in the traditional IRA at retirement. But by paying the conversion tax from the Roth IRA–instead of from the traditional IRA–you’re able to convert your entire traditional IRA, keeping the funds in the Roth IRA (and potentially benefitting from the hoped-for appreciation) until you actually make a withdrawal from the Roth IRA to pay the tax.

And you can always recharacterize if things go wrong

But what happens if you turn out to be wrong, the FDA does not approve Acme’s drug, and the stock drops to $1? Well, in that case, you can simply undo the conversion. You have until October 15, 2016, to recharacterize the Roth IRA back to a traditional IRA, and for tax purposes you’ll be treated as though the conversion never happened (with no resulting tax bill, or a tax refund if you already paid taxes on the conversion).

Before taking any specific action, be sure to consult with your tax professional.

1This hypothetical example is not intended to reflect the actual performance of any specific investment, nor is it an estimate or guarantee of future value.

2If you wait until April 15, 2016, to actually withdraw funds from the Roth IRA to pay the conversion taxes, do you need to worry about paying estimated tax on the $100,000 of conversion income? Technically, yes. You might need to increase your withholding on other income, or make estimated tax payments, as a result of the conversion.

But keep in mind that there are a number of important exceptions to the estimated tax payment rules. For example, if your tax withholding for 2015 is at least equal to your 2014 tax liability, you generally would not be required to make estimated tax payments, and you would not be subject to an underpayment penalty, regardless of the amount of your Roth conversion income.


Investment advisory services offered through Austin Wealth Management, LLC, a registered investment advisor.
Austin Wealth Management’s outgoing and incoming e-mails are electronically archived and subject to review and/or disclosure to someone other than the recipient. We cannot accept requests for securities transactions or other similar instructions through e-mail. We cannot ensure the security of information e-mailed over the Internet, so you should be careful when transmitting confidential information such as account numbers and security holdings. If the reader of this message is not the intended recipient, or an employee or agent responsible for delivering this message to the intended recipient, you are hereby notified that any dissemination, distribution or copying of this communication is strictly prohibited. If you have received this communication in error, please notify us immediately by replying to this message and deleting it from your computer.

Securities offered through Purshe Kaplan Sterling Investments, Member FINRA/SIPC

Headquartered at 18 Corporate Woods Blvd., Albany, NY 12211.
Purshe Kaplan Sterling Investments and Austin Wealth Management, LLC are not affiliated companies.
Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2014.
Kevin X. Smith, CFA
512.467.2003   |  [email protected]

Kevin is responsible for advising clients for whom he is the lead financial advisor. He also manages the operations and development of the firm, and oversees all of the investments of Austin Wealth Management clients. Kevin is on a mission…Read More

Return to Blog Page