"Funding" a Future Tax Liability from a Roth Conversion

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bestplans
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"Funding" a Future Tax Liability from a Roth Conversion

Post by bestplans » Fri Sep 05, 2014 5:29 pm

For someone planning to retire in 6-8 years with a large traditional 401K balance and a plan to perform Roth Conversions during the window between the beginning of retirement and collecting a pension/SSN (when the tax bracket is lowest), does it make sense to start setting aside additional money in short term investments to "save" for the tax liability (to avoid taxes being paid out of the 401K balance withdrawn)? The downside of course being straying away from one's allocation to equities (and likely giving up higher return potential)? Or would this simply be an example of a tail wagging the dog scenario (letting decisions re: taxes make one deviate from the more important investment plan)? Thanks all.

dickenjb
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Re: "Funding" a Future Tax Liability from a Roth Conversion

Post by dickenjb » Fri Sep 05, 2014 5:50 pm

If you cannot pay the taxes for Roth conversion from taxable moneys you should not be doing Roth conversions.

I have no idea why investing money in taxable makes you believe you have to reduce your equity allocation. VTSAX is a fine tax efficient investment in a taxable account, as is VTIAX. Keep your overall AA the same by rebalancing in tax advantaged.

coacher
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Re: "Funding" a Future Tax Liability from a Roth Conversion

Post by coacher » Fri Sep 05, 2014 6:04 pm

It appears the OP is asking whether it makes sense for him/her to start "saving" for this future tax liability with after tax funds in safe investments (like CDs) so he/she knows the money will be there, vs. putting more in after tax equities that he/she may not want to liquidate at the time of the conversion. Is that really what you are getting at?

bestplans
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Re: "Funding" a Future Tax Liability from a Roth Conversion

Post by bestplans » Fri Sep 05, 2014 6:06 pm

Yes exactly! I'm not sure if I am thinking about this the right way or overcomplicating the situation.

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grabiner
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Re: "Funding" a Future Tax Liability from a Roth Conversion

Post by grabiner » Fri Sep 05, 2014 6:33 pm

Continue to max out the 401(k). If you contribute to the 401(k) now, and withdraw the same money from the 401(k) to pay taxes when you convert in ten years, you have gained ten years of tax-deferred growth, and you probably deducted the contribution in a lower tax bracket than you paid on it.

If you are maxing out the 401(k), keeping the money for the planned tax bills in a bond fund makes sense. If you tax-adjust your asset allocation, converting a traditional IRA full of bonds into a Roth IRA full of bonds decreases your bond allocation, so it makes sense to pay the taxes out of a bond fund.
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Re: "Funding" a Future Tax Liability from a Roth Conversion

Post by MN Finance » Fri Sep 05, 2014 7:22 pm

It's fine, but if you actually think about it, you don't want to save the tax liability in safe assets. You want it to be invested in the asset you're going to convert because they move together. That said I really don't think this matters one way or another.

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