Roth conversion in high-taxed states is a very bad idea

There are plenty of good reasons why people choose to convert a traditional individual retirement account or 401(k) plan to a Roth IRA. And there are some very bad reasons, as well. The bottom line is that everyone needs to take into the consideration the most important — and often overlooked — factor: state income taxes.

Here's the thing: Retirement income, whether from pensions, individual retirement accounts or annuities, is taxed based upon the state you reside in during retirement and not the state in which you worked and accumulated the benefits.

Roth IRA
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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, such as Florida or Texas, you have the option of avoiding state income taxes on both retirement savings as well as retirement income.

When you contribute to a traditional retirement plan, you receive a current tax deduction for both federal and 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 pretax 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.

"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."

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 on your retirement might be huge. For example, in California the top income-tax bracket exceeds 13 percent. If you are in the top income bracket and convert a retirement account to a Roth IRA while you are a resident of the Golden State, you'll be forced to pay 13 percent. 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 percent 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 free of state income taxes 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.

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This same logic applies to contributions to Roth 401(k) plans 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