Impact of State Taxes on Traditional to Roth Conversion

We have discussed at length about Roth IRA and about the conversion of traditional IRA to Roth IRA. There are several benefits of conversion and in a low tax atmosphere, it becomes an interesting proposition for many.

When you convert a 401(k) or a traditional IRA to a Roth IRA, you’re making a decision to pay income taxes today for the promise of a tax-free income tomorrow. This can be a wise choice if you feel that you will be in a higher tax bracket at the time of retirement. Considering how low the taxes are today and how much debt the government is taking up, there is a very high likelihood that tax rates would be higher at the time of retirement. Those who are investing successfully find Roth IRA promising as they may have a higher income in retirement and taxes are potentially going to be higher as well.

There is one aspect that generally gets overlooked while talking about this conversion and that is State Taxes. When you are converting traditional IRA to Roth (Backdoor Roth included), it not just triggers federal income tax but also state income tax in the state you currently reside. This can be a huge impact if you currently live in a high tax state like New York or California vs a low tax or a tax-free state or outside of US.

Yes, for expats, one key thing that should be on their To-Do if they live outside of US for a substantial part of a tax year is the conversion of traditional IRA to Roth. As of today, there are seven states (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) with no income tax and several others that do not tax retirement income but there are several states that have high-income tax rates as well. Retirement withdrawals are taxed based on the rates of the state in which you reside so if you reside in New York, you pay NY state tax.

This is one of the reasons why low tax states are also high on the list of retirement destination with several folks looking to retire outside of US as well. In these situations, you pay $0 state tax irrespective of if you withdraw from Traditional IRA or Roth IRA.

If you plan to move out of your current high tax-rate state to a location with no state income tax, converting to Roth IRA may not make much sense. There are some circumstances where it may still work out e.g. any prolonged period of unemployment. In that scenario, you may be able to avoid high state tax burden or keep it minimal enough to materialize your plans for paying little tax and get tax-free investments.

If you by any chance are in a low tax state right now, try to convert as much as possible to Roth IRA and avoid paying taxes on it in future.

 

DNA - They guy next door
Dee is a technologist and a personal finance hobbyist. With over 15 years of experience in the financial domain, Dee started following the philosophy of FIRE since 2016 and is on track to reach the goal of FIRE in 10 years. He wants to teach you on how to achieve Financial Independence within a decade. All content on this site is an opinion and is for information purposes only.  It is not intended to be investment or tax advice.  Seek a duly licensed professional for investment and tax-related advice

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