There are plenty of good reasons why people choose to convert a traditional IRA or 401(k) to a Roth IRA. And there are some poor reasons as well. But one of the most important factors that is often overlooked is state income taxes.
Here’s the thing: Retirement income, whether from pensions, IRAs or annuities, are taxed based upon the state you reside in during retirement, and not the state in which you worked and accumulated the benefits. For example, if you spend your working years in a high income tax state, such as New York or California, and you then retire in a low income tax state like Florida or Texas, you have the option of avoiding state income taxes on your retirement savings as well as your retirement income.
When you contribute to a traditional retirement plan you receive a current tax deduction for both federal as well as state income taxes. You also avoid income taxes on the growth in the plan. It’s only when you withdraw money from the plan that you are subject to both federal and state income taxes.
A Roth IRA or 401(k) is just the opposite. You don’t receive any current tax deduction, but your retirement withdrawals will be income tax-free.
Once you take a pre-tax retirement account, such as a traditional IRA, and convert that account to a Roth IRA, you are subjecting your retirement dollars to both federal and state income taxes today in return for the promise of tax-free income during retirement.
This might work fine if you are in a lower tax bracket today and believe you’ll be in a higher tax bracket during retirement. But a Roth conversion might be a foolish thing to do if you plan on leaving the high-taxed state of your working years to retire in a state that levies no income taxes.
The impact this could have on your retirement might be huge. For example, in California the top income tax bracket exceeds 13%. If you are in the top income bracket and convert a retirement account to a Roth while you are a resident of the Golden State, you’ll be forced to pay 13%. If you plan on leaving California for Texas or Nevada upon retirement, as thousands of Californians do, your federal tax rate would have to be at least 13% higher just for a Roth conversion to break even.
So, if you plan on moving out of your current high-taxed state and retiring in a non-taxed state, why would you want to convert anything to a Roth IRA? By doing so, you would be taking money that would be state income tax-free during retirement and making those dollars taxable today. And if your current state has high income taxes, you could be forking over a considerable amount of money today for absolutely zero benefit to you during your golden years.
There are some circumstances where a Roth conversion still might make sense, such as during a period of prolonged unemployment, but for those who are confident they’ll be leaving their state when they retire, the vast majority of the time a Roth conversion is simply a bad idea.
This same logic applies to contributions to Roth 401(k)s and Roth IRAs. Again, using the traditional plans may have greater benefit if you leave your high-taxed state upon retirement.
— By Scott Hanson, senior partner at Hanson McClain Advisors.