Roth IRA and income tax

[cspyon1]

I would like to double-check with you on this, though I asked some of you before.

To put it simply, I'm going to transfer $25,000 from my retirement plans (401K) to Roth IRA.

I've got two options: 20% federal tax now or withholding it until the tax-filing time next spring. 

The thing is even with the addition of $25,000 to my annual income, I'm still in the 12% federal tax brackets. 

Do you think I can get more benefits from paying the tax later (in the 12% brackets) than paying the federal tax (20%)?  

[macuser_22]

@cspyon1 - You asked the same question here and it was fully answered and discussed.  What do you not understand?

https://ttlc.intuit.com/community/retirement/discussion/re-tax-implications-on-the-conversion-of-tra...

[cspyon1]

Okay, for the sake of calculation, let me put it this way.

If I pay 20% federal tax of $25,000, it's $5,000.

Say I add this amount to my estimated income of $30,000, for example.  Now, it's $55,000.

As I pay the federal tax upfront, the actual amount to convert to Roth IRA is $20,000.

Then, my total estimated income is $50,000, which puts me in the 12% federal tax bracket.

Here, my tax is $6,000 ($50,000 divided by 0.12).  But as I have paid $2,000 upfront in federal taxes,

the total taxes I would pay would be $8,000.

Now, let me withhold the federal tax and add the whole contribution ($25,000) to my estimated income.

It's now $55,000, which puts me in the 12% federal tax bracket.

So, 12% of $55,000 (assuming I withhold the federal tax) is $6,600.

In other words, $8,000 vs $6,600, to put it simply. Withholding is more beneficial to me, isn't it?

Am I right or wrong? 

[VolvoGirl]

One thing you missed is in both scenarios you took out 25,000.  25,000 is added to your income.  It's not how much you contribute to the ROTH IRA but the total withdrawal whether you take out withholding or not.  So your income is 55,000 both times.

[macuser_22]

You are confused.   The taxable income for the 401(k) distribution is the amount of the distribution period.   It makes no difference whatsoever if part of that is withheld for tax or not - the amount withheld for tax is also taxable income.    Either way, if you have a $25,000 distribution  then $25,000 will be added to your AGI as taxable income.    

The difference is if you have $5,000 withheld for tax then only $20,000 can go to the IRA to grow, but if you can pay the tax form other funds then the entire $25,000 can grow int he IRA.

That is an *investment* decision that you must make and has nothing to do whatsoever with the taxable amount of the distribution.

If you thought that the tax withholding was not taxable (meaning that if you took a $25,000 distribution and had $5,000 withheld for tax so only $20,000 would be taxable) then  you are wrong.  The entire amount of the $25,000 distribution is taxable reguardless of what you do with the money - spend it, invest it, or use it to pay your tax.  It cam from the 401(k) so it is taxable.

The only way to avoid the tax is to roll the 401(k) into a Traditional IRA and not convert it to a Roth IRA.

[cspyon1]

In that case, I pay $5000 tax upfront, and get taxed again for the $25,000 when the actual contribution to Roth IRA is $20,000? 

What's the point of paying the tax upfront then?

Isn't it more wise for me to wait until the tax filing? 

[VolvoGirl]

The point is so you don't end up owing a lot on your tax return. You can owe an underpayment penalty if you owe too much on your tax return like 1,000 or more.

If you have withholding taken out you can add it back into the ROTH IRA contribution deposit from your own other money to replace it.  So you can still deposit the full 25,000.

[cspyon1]

So, even if I pay 20% federal tax now, do you mean I still have to pay the tax for $25,000, not $20,000? What's the point of paying the tax now?

[VolvoGirl]

Right.  Now you're getting it.  See my post above.

[VolvoGirl]

Oh and you are not paying the federal tax now.  You are having withholding taken out like from your paychecks.  It is just an estimate to cover the actual tax calculated on your tax return.  Then you get credit for the withholding taken out.

[cspyon1]

When I fill out the online form on this transfer to Roth IRA, I see three options:

1) default federal tax (20%) 

2) fixed percent (must be above 20%)

3)do not withhold taxes

So, when I asked my pension compay, they say if I choose 1), the ACTUAL l amount to transfer to my Roth IRA is $20,000 ( $5,000 withheld).

This is where I got confused. According to your explanation, my pension company withholds $5,000 to pay for federal taxes later, but the actual amount to transfer to Roth IRA  is still $25,000, not $20,000 now? 

[VolvoGirl · Accepted solution]

The taxable DISTRIBUTION is still 25,000.  The transfer is only 20,000.  But you can add back in the 5,000 with your own money from your checking account, etc.  to replace the 5,000 so the whole 25,000 gets into the ROTH IRA.   I think you have 60 days to make the deposit.  

[cspyon1]

Got it. I don't want to add another $5,000 to make up for my original Roth IRA contribution, though.