tax implications on the conversion of traditional IRA to Roth IRA

[cspyon]

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? 

[VolvoGirl]

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.  

[macuser_22]

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.

[cspyon]

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? 

[VolvoGirl]

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.

[macuser_22 · Accepted solution]

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.

[cspyon]

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?

[VolvoGirl]

Only pay tax on the amount you convert.  Once it's in the ROTH IRA it grows tax free.

[cspyon]

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. 

[VolvoGirl]

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.

[dmertz]

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.

[Opus 17 · Accepted solution]

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@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.

[macuser_22]

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@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. 

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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.)

[Opus 17]

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@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. 

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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.  

[cspyon1]

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.