Okay, this is my question.
I've got an employer-sponsored retirement plan and Roth IRA.
Now, I want to roll over the whole fund (about $1,7000) of one plan to Roth IRA.
I've got two options: 20% Federal tax pay now, or pay later during the tax filing season next year.
Which is better for me? If I pay the tax later, does this taxable fund count as income in my adjusted gross income? Even this taxable fund is added to my income, I belong to the 12% tax bracket zone.
What do you think is the best solution for me?
Most financial planers will advice to always pay the tax on a Roth conversion separately if possible, to preserved the retirement principle. If only 80% of the 401(k) is converted then it will probably take many years for it to grow back to the current value.
You should not wait until tax time next year to pay the tax, it should be paid as an estimated tax in the quarter that the conversion is done to avoid an underpayment of tax penalty. Taxes are pay as you go. If you wait until tax time and owe more than $1,000 tax then there can be an underpayment penalty if estimated tax is not paid during the year.
@dmertz wrote:
The entire $17,000 gross distribution will be added to your AGI whether you have taxes withheld or not. However, only the portion of the $17,000 that makes it to the Roth IRA is the amount converted and the portion that does not make it to the Roth IRA is a distribution made to you, even if it goes to tax withholding. If you are under age 59½ at the time of the distribution, the portion that does not make it to the Roth IRA will also be subject to a 10% early distribution penalty.
The generally recommended method of doing such a conversion is to convert the entire gross amount, with no amount withheld for taxes, and to use other funds make an estimated tax payment for the tax quarter in which the distribution from the traditional retirement account occurs. Assuming a sufficient estimated tax payment, this should avoid any underpayment penalty for not paying the taxes timely.
I was just going to say the same thing. Anything that is withheld for taxes is not part of the conversion and you will pay an extra 10% penalty for early withdrawal, unless you are over age 59-1/2, or you separated from service with the employer when you were age 55 or older.
If you think you will be in the 12% bracket, and you can't come up with $2040 for the full income tax this year, you might want to convert the money in steps over a couple of years.
Also note, if you left this employer and they are pressuring you to close your account, you can transfer the money to a traditional IRA with no tax consequences and no withholding, as long as you do a direct institutional transfer. Then, you could convert the money from the traditional IRA to a Roth IRA in stages when you can afford to pay the tax.
You aren't paying the tax now. It is withholding like from your paychecks. Yes you should have withholding taken out so you don't owe too much when you file your tax return.
Either way it will be included in your income next year.
First, an employer sponsored retirement plan is NOT a Traditional IRA - it is probably a 401(k) plan.
Any tax withholding is part of the distribution and will be taxable income include in your AGI. If you can rollover the entire amount and pay estimated tax from other funds then there will be more money to convert conserving the retirement account. That is usually recommended of you can afford the tax from other funds.
So, which is better, pay 20% federal tax of this amount at the time of conversion, or pay it as part of my adjusted gross income during the tax filing time (12% tax bracket band) next year?
Either way you want. You will get a 1099R for it and still enter the full amount converted as income. Then all your withholding (W2 and 1099R) is subtracted from the tax due. If you don't have withholding taken out you may owe a penalty on your tax return for not paying in enough during the year. Are you converting 1,700 or 17,000? It will increase your AGI and may push you into a higher tax bracket. So be careful.
Most financial planers will advice to always pay the tax on a Roth conversion separately if possible, to preserved the retirement principle. If only 80% of the 401(k) is converted then it will probably take many years for it to grow back to the current value.
You should not wait until tax time next year to pay the tax, it should be paid as an estimated tax in the quarter that the conversion is done to avoid an underpayment of tax penalty. Taxes are pay as you go. If you wait until tax time and owe more than $1,000 tax then there can be an underpayment penalty if estimated tax is not paid during the year.
Hummmm... if I decide to wait until next year, do I need to pay not only the tax for the original transferred amount ($17,000) but also for its growth (from not till the end of the year), too? For example, if the original amount of $17,000 grew to $20,000, do I have to pay for the additional growth of $3,000 later? Does that mean I may have to pay what you refer to 'underpayment' penalty?
Only pay tax on the amount you convert. Once it's in the ROTH IRA it grows tax free.
Okay, that's good to know!
So, if I understand correctly, this is what it looks like:
1) pay federal tax (20%) for $17,000 now. In this case, I pay $3,400 from the fund, so the actual transfer amount is $13,600 into Roth IRA.
2) pay the tax later. In this case, $17,000 is in Roth IRA, and it will be added to my annual self-employed income (12% tax bracket for now) and pay the tax in this bracket, not in the 20% bracket.
3) Once the fund is in Roth IRA, it will grow tax-free without me having to worry about the so-called underpayment penalty.
You should have the 20% withheld when you transfer it. Or as the other answer said transfer the full 17,000 and send in an estimated payment to cover the tax. If you end up owing too much on your tax return there is an underpayment penalty.
Are you sending in quarterly estimates for your self employment income? You can increase one to cover the conversion amount. Just cross out the amount on the 1040ES and write in a new amount.
The entire $17,000 gross distribution will be added to your AGI whether you have taxes withheld or not. However, only the portion of the $17,000 that makes it to the Roth IRA is the amount converted and the portion that does not make it to the Roth IRA is a distribution made to you, even if it goes to tax withholding. If you are under age 59½ at the time of the distribution, the portion that does not make it to the Roth IRA will also be subject to a 10% early distribution penalty.
The generally recommended method of doing such a conversion is to convert the entire gross amount, with no amount withheld for taxes, and to use other funds make an estimated tax payment for the tax quarter in which the distribution from the traditional retirement account occurs. Assuming a sufficient estimated tax payment, this should avoid any underpayment penalty for not paying the taxes timely.
Subsequent earnings within the Roth IRA will be tax and penalty free once you have met the requirements for qualified Roth IRA distributions. If you are under age 59½, distributions of the converted amount will be income tax free but subject to an early-distribution penalty if distributed prior to 5 years after the beginning of the year in which the distribution from the traditional retirement account occurred.
@dmertz wrote:
The entire $17,000 gross distribution will be added to your AGI whether you have taxes withheld or not. However, only the portion of the $17,000 that makes it to the Roth IRA is the amount converted and the portion that does not make it to the Roth IRA is a distribution made to you, even if it goes to tax withholding. If you are under age 59½ at the time of the distribution, the portion that does not make it to the Roth IRA will also be subject to a 10% early distribution penalty.
The generally recommended method of doing such a conversion is to convert the entire gross amount, with no amount withheld for taxes, and to use other funds make an estimated tax payment for the tax quarter in which the distribution from the traditional retirement account occurs. Assuming a sufficient estimated tax payment, this should avoid any underpayment penalty for not paying the taxes timely.
I was just going to say the same thing. Anything that is withheld for taxes is not part of the conversion and you will pay an extra 10% penalty for early withdrawal, unless you are over age 59-1/2, or you separated from service with the employer when you were age 55 or older.
If you think you will be in the 12% bracket, and you can't come up with $2040 for the full income tax this year, you might want to convert the money in steps over a couple of years.
Also note, if you left this employer and they are pressuring you to close your account, you can transfer the money to a traditional IRA with no tax consequences and no withholding, as long as you do a direct institutional transfer. Then, you could convert the money from the traditional IRA to a Roth IRA in stages when you can afford to pay the tax.
@cspyon wrote:
Okay, that's good to know!
So, if I understand correctly, this is what it looks like:
1) pay federal tax (20%) for $17,000 now. In this case, I pay $3,400 from the fund, so the actual transfer amount is $13,600 into Roth IRA.
2) pay the tax later. In this case, $17,000 is in Roth IRA, and it will be added to my annual self-employed income (12% tax bracket for now) and pay the tax in this bracket, not in the 20% bracket.
3) Once the fund is in Roth IRA, it will grow tax-free without me having to worry about the so-called underpayment penalty.
1) If you have $3,400 *withheld* to pay the tax, the you only have $13,600 left to convert to the IRA so it will have to grow back to $17,000 just to break even. The entire $17,000 distribution will be taxable income including the $3,400 withholding but if you are under age 59 1/2 then the $3,400 will also be subject to a 10% ($340) early distribution tax.
2) If you pay the *estimated* tax at the time of the distribution, (not later) using other funds, then the entire $17,000 can be converted with not loss for taxes. Either way the entire $17,000 is added to your AGI and is taxable income - the only difference is how the tax is paid.
3) The "underpayment" penalty has nothing to do with the IRA. The penalty is based on how much additional tax that you must pay to the IRS when you file your tax return. If $1,000 of more then there can be a penalty - paying estimated tax before filing avoids the penalty. (Withholding and estimated tax are almost the same. With withholding the account custodian removes the money and sends it to the IRS, with estimated tax you send it to the IRS.)
@cspyon wrote:
Okay, that's good to know!
So, if I understand correctly, this is what it looks like:
1) pay federal tax (20%) for $17,000 now. In this case, I pay $3,400 from the fund, so the actual transfer amount is $13,600 into Roth IRA.
2) pay the tax later. In this case, $17,000 is in Roth IRA, and it will be added to my annual self-employed income (12% tax bracket for now) and pay the tax in this bracket, not in the 20% bracket.
3) Once the fund is in Roth IRA, it will grow tax-free without me having to worry about the so-called underpayment penalty.
Unless you are over age 59-1/2, or you left this employer at age 55 or older, the only not-stupid thing to do is:
4) convert the entire amount to a Roth IRA with no withholding, and make an estimated payment to the IRS in the amount of $2040 from other funds (if you are sure you will be in the 12% tax bracket). You will also likely need 5% or so to make an estimated state tax payment, depending on what state you live in.
Even if you have to borrow the $2000 to pay the tax, you come out ahead as long as you pay less than $300 of interest when you pay off the loan.
If you can't come up with $2000 now to pay the tax up front from other funds, maybe you can come up with $1000 and convert half this year and half next year.
Thanks for your kind and detailed explanation.
It looks like paying the federal tax upfront is a better option for me. I don't want the tax-related headache later.
Oh I forgot to ask this one.
Aside from the transfer (or rollover) of $17,000 to Roth IRA, can I still make the new contribution to Roth IRA (I'm eligible for up to $7,000 per year)?
Yes. The transfer doesn't affect new contributions. By the way, are you doing the transfer from a Traditional IRA or an employer 401K plan? That wasn't clear.
Got it. It's an employer-sponsored tax-deferred annuity plan that I want to roll over to my Roth IRA.
When I convert $15,000 from my IRA to Roth, $2000 went to tax withholding and $13,000 made it to my ROTH. I also took $35,000 RMD including Tax withholding. The 1099R is for both.
TT tax asked me: Amount converted to ROTH IRA account?
What is the answer?
Unless you replaced the withholding with your own money then you only converted the 13,000. The 2,000 withholding becomes a distribution.
So the best is to maximized conversion with no tax withholding and pay estimate tax separately, Correct?
So I should say $13,000 is my Roth conversion as this is the actual number going to my ROTH account.
The $2,000 is a Distribution, taken just to help pay the federal and state taxes.
Correct Madam?
Thank you very much.
I should do no tax withholding and make estimate tax payment separately. That way I can convert more to ROTH.
By taking a distribution of $2,000 for tax withholding is not a wise move.
Vey good lessons leant.
Thanks again.
@SLYKTAX wrote:
Thank you very much.
I should do no tax withholding and make estimate tax payment separately. That way I can convert more to ROTH.
By taking a distribution of $2,000 for tax withholding is not a wise move.
Vey good lessons leant.
Thanks again.
Not necessarily. I could go into the detailed rules of why I am making these tips, if necessary, but here are some tips:
1. If you convert in the last quarter of the year, and don't have withholding, you can be hit with an underpayment penalty, even if you make the correct estimated payment on time. Having withholding avoids this penalty.
2. Once way to make a complete conversion is to add extra money. You can do this within 60 days and call it a rollover. For example, you convert $15,000 on December 1 and want to withhold $3000 for taxes. $12,000 goes into the Roth IRA on December 2. You have 60 days to deposit $3000 into the Roth IRA from other money (savings account, other investments) and call it a rollover. Just tell the Roth IRA it is a rollover, they don't need to know or care that it is part of the conversion. It all works out on your tax return. Of course, this is assuming you have the money to cover the difference in another account you can pull from.
This is probably the best way to make a late-in-the-year conversion without paying a penalty for under-withholding, as long as you have the separate funds to cover the taxes.
3. However, if you convert in the first quarter of the year, you have 4 quarters to make estimated payments and not pay a penalty. For example, you convert $15,000 on February 1 and have no taxes withheld. You determine that your estimated tax payment should be $3000. You could pay the full $3000 by the deadline for the first quarter, which is April 15. Or, you could pay equal quarterly estimates of $750 on April 15, June 15, Sept 15, and Jan 15 of the next year, and you would be considered in compliance with the rules on estimated payments, even though you delayed part of the estimate for almost a year.
I could go into details, but this has to do with how the IRS determines the tax due dates for earnings, withholdings, and estimated payments. Anyway, the bottom line is that converting late in the year and not having withholding can result in a penalty. You can avoid this by converting late in the year, having withholding, and depositing the make-up funds as another rollover; or by doing the conversion early in the year.
Cheers.