Use other assets
By turning to other liquid assets to fund the tax bill for your Roth conversion, you'll keep your Roth IRA robust, with potential for greater growth. Mantell cautions against tapping into funds set aside for other financial goals, or if you need your assets to help you get out of debt before retiring.
The best options are accumulated cash savings such as funds held in a savings account or CD. Another alternative is to sell securities held in a brokerage account to pay the taxes, although those sales are considered taxable events and may add to your tax bill. Avoid that problem by selling "a loser investment" so the loss can be offset against your income, Bankrate's McBride says. Or sell a winner "if your gains would be balanced by losses on other securities," says Stephen Mitchell, a consultant and chief operating officer of the Retirement Income Industry Association.
Just don't forget to consider the consequences. Depending on which assets you use to pay the taxes, "you may need to rebalance those other investments to get you back to your investment strategy, which could incur an additional tax bill," Mitchell says. "For instance, if you use your emergency fund to pay the taxes, you will probably want to replenish that emergency fund and you may have to liquidate other assets to do that," which could result in a taxable event.
If coming up with cash to pay taxes on your entire IRA isn't feasible, consider converting a portion of the account rather than the whole thing. "It's not an all-or-nothing proposition," Mitchell says.
Use life insurance proceeds
For some families, a good strategy may be to simply purchase life insurance now, says Dave Freitag, marketing officer for Impact Technologies, a software manufacturer for the financial services industry that has just released a new suite of Roth IRA conversion analysis tools. Upon the death of the IRA owner, the spouse or dependent can convert the IRA to a Roth, use the life insurance to pay the taxes, and receive tax-free payments throughout retirement or stretch the tax-deferred dollars over multiple generations.
This strategy would only work for investors who want to leave the money in their IRAs to their beneficiaries, rather than use it for their own retirement. In that situation, "the life insurance simply creates the cash needed to fund the expense of the (Roth) conversion," Freitag says. "Frequently, liquid funds are not available to the surviving spouse to make this type of tax payment. The insurance money shows up at just the right time."
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