There are a lot of articles being written about people converting to Roth IRAs because they’re going to be in a higher tax bracket when they retire. One thing these articles almost always fail to mention is the impact, usually negative, that state income taxes could have once this is done. In fact, converting to a Roth IRA may not be best decision for everyone simply because of this fact alone.
Simply put, when you convert a 401(k) plan(or a traditional IRA) to a Roth IRA, you’re making the decision to pay income taxes today so that you’ll be able to make income tax-free in the future. If you’re fairly confident that you’ll be in a higher tax bracket once you retire (and that Congress will dramatically change the tax rules on Roth IRA withdrawals before then), it can be a wise choice.
People with high incomes who are saving and investing successfully usually continue to have high income once retired. Although this make sense, it also leads them to the line of reasoning that will they should pay today’s current tax levels, then enjoy tax-free income once they retire. Those people are under the impression that taxes are going to be higher in the future, which is not actually incorrect but is also not a certainty.
The problem is that converting from a 401(k) or traditional IRA to a Roth IRA triggers taxable income in your state as well as federal income taxes when you file taxes. Seven states actually don’t have income tax, including Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming, but all the rest do and some are quite prohibitive. For example, California is around 13% in New York 9%.
So if you decide to convert to a Roth IRA are not only going to have to pay federal income taxes to Uncle Sam but you’ll also be funding your state government with a check for possibly thousands of dollars. Obviously that’s the reason that most people move from States with higher taxes to States with a lower tax burden.
You need to keep in mind is that retirement withdrawals are taxed based on the rate of the state in which you reside when you make your withdrawals. If you withdraw from your 401(k) or traditional IRA in a state which is tax-free, you won’t pay taxes there. If you convert to a Roth IRA in a state that has 9% taxes but then, in retirement, move to a state where there are lower or zero taxes, you’re actually losing money today and getting no benefit tomorrow.
This same logic applies to retirement savings using a Roth 401(k) plan. If you have plans to leave your high taxed state after you retire and move to a state with lower taxes, a traditional plan may have greater benefit today.
So, if you’re considering converting your 401(k) or traditional IRA to a Roth IRA, the first thing you should do is look at your plans where you’re going to be living after retirement. If those plans include moving to a state with lower or zero taxes, your decision to convert today might not be a good one.