You can transfer money from an individual retirement account (IRA) to a post-tax account — but how much tax do you pay on this Roth IRA conversion? And does it always make financial sense to do so?
- You can transfer money from a traditional Individual Retirement Account (IRA) or 401 (k) to a Roth IRA by making a Roth IRA conversion.
- If you make a Roth IRA conversion, you owe income tax on the entire amount you convert — and it can be significant.
- If you are at a higher tax rate upon retirement, the long-term benefits may outweigh any tax you pay on the conversion now.
The biggest difference between Roth IRAs and deferred tax accounts, like traditional IRAs and 401 (k) s, is when you pay tax:
- Traditional IRA and 401 (k) contributions are tax deductible for the year you make them and you pay income tax on retirement withdrawals. The money you pay and the money you earn are both taxable.
- Roth IRA contributions do not offer upfront tax relief, but retirement withdrawals are tax-free.
Why a Roth IRA conversion?
There are a few reasons to consider Roth IRA conversion (also called reversal). If you want to contribute directly to a Roth, but earn a lot of money to qualify, you can legally exceed the income threshold by making a Roth IRA conversion. This strategy is often called backdoor Roth.
Another good reason to make the transition: Expect to be at a higher tax rate on retirement than you are now. Remember, Roth IRA withdrawals are tax-free at retirement — even when you make a profit. You can pay taxes now while you are in a lower tax range and enjoy tax-free withdrawals later.
How to do a Roth IRA conversion
If you decide that a Roth IRA conversion makes sense to you, here are some things you can do to help:
- Put money in a traditional IRA (or other retirement account). You will need to open and fund a new account if you do not already have one.
- Pay taxes on your IRA contributions and earnings. If you deducted your traditional contributions from the IRA (which you did if you met income limits), you must return this tax deduction now.
- Convert account to Roth IRA. If you do not yet have a Roth IRA, you will open one when converting.
There are some ways to do the conversion:
- Indirect overthrow. You receive a delivery from your traditional IRA and put it in your Roth IRA within 60 days.
- Overthrow of an administrator in a trustee. Ask the traditional IRA provider to transfer the money directly to the Roth IRA provider.
- Own transfer of administrator. If the same provider holds both of your IRAs, you can ask that provider to do the transfer.
How much tax will you owe on a Roth IRA conversion?
When you convert from a traditional IRA to a Roth IRA, the amount you convert is added to your gross income for that tax year. It increases your income and you pay the normal conversion rate.
Suppose you are in the 22% tax category and convert $ 20,000. Your income for the tax year will increase by $ 20,000. Assuming this does not push you to a higher tax rate, you will owe $ 4,400 in conversion taxes.
Be careful here. It is never a good idea to use your retirement account to cover the conversion tax you owe. This will reduce your retirement balance, which could cost you thousands of dollars in long-term growth. Instead, save a considerable amount of cash in a savings account to cover conversion taxes.
Conversion from 401 (k)
If you want to transfer money from your 401 (k) to a Roth IRA, make sure the money is transferred directly to your Roth IRA provider. If not, your company will withhold 20% of the amount for tax purposes.
If your company issues a check to you (instead of transferring it to your Roth IRA provider), here’s what happens: You only have 60 days to deposit all your money into a new Roth — including the 20% you did not receive. If you do not meet this deadline — and if you are under 59 years old — then you will owe a 10% early withdrawal penalty on any money that has not reached Roth.
Either way, you are still ready for income taxes for the entire amount you are converting.
Do not wait all year to pay
Most people pay their income tax in the public sector with every salary. It is automatically deducted, based on the deductions you claim in Form W-4. As the year goes on, your taxes are withheld for you. You do not need to write a separate check to the government until you have paid your taxes. And only if you did not get enough money and you still owe.
However, small business owners and corporations make estimated quarterly tax payments. These entities need to estimate how much tax they will owe based on their income and expenses. And then every quarter – usually on April 15, June and September of the same year and January of the following year – they fill out a form and send their payments.
Why is this important to note? If you convert a major traditional IRA to a Roth IRA at the beginning of the year, then your quarterly income – and therefore your quarterly taxes – will increase.
Suppose you made a conversion in the first quarter of the year. You will need to pay the tax caused by the conversion when the quarters expire. In this example, this would be until April 15th.
If you wait until the end of the year or when you file your taxes, you may owe fines and interest.
Safe Harbor Rules
If you’re used to paying estimated taxes, you may be wondering about safe harbor rules. Safe harbor rules mean that if you pay at least 100% (or 110%, depending on the situation) of last year’s taxes on estimated taxes this year, then you will not pay any fees or interest on the down payment.
This is to protect individuals and businesses whose incomes can skyrocket — thanks to a wonderful year — after a poor year. Provided you have paid at least as much as last year, you will be taken to the “safe harbor”. And you will not have to worry about penalties and interest.
However, things can get stuck here and it is a good idea to talk to a tax advisor. Of course, if you pay your estimated taxes, you will have nothing to worry about. If you end up paying too much into the tax system, you will receive a refund when you file your taxes at the end of the year.
Do I need to convert a Roth IRA?
The Roth IRA offers huge benefits — tax-free withdrawals during retirement and no minimum distributions required (RMDs), to name just two. However, a conversion is not always a good idea.
In general, you should only consider a conversion if:
- You can pay taxes from your savings account without pressing IRA funds.
- Are you sure you will be at a higher tax rate when you retire?
Keep in mind that you could be at a higher tax rate later in life, even if you do not earn more money at work. Your income can be higher due to any combination:
Be sure to consider these other sources of income when calculating your future tax rate.
When Should I Consider Converting an Individual Roth Retirement Account (IRA)?
Converting a Roth Individual Retirement Account (IRA) may be wise if you think you will be in a higher retirement tax rate than you are now. If you have to pay taxes on traditional IRAs when converting them, think about your current tax rate and the value of your current account. If the market is declining, there is less taxation than at a time when your capital is doing well.
How do I know if I will be in a higher tax position later?
There is no real way to know what the tax code will look like when you retire — unfortunately, it changes often. What you can determine is how many sources of funding you will have in your retirement. If you have a pension, income, rental property or other passive income streams, you can earn as much or more in retirement as you do now. In 2022 we are in a historically low tax period, so plan accordingly.
How much can I be penalized for underpaying my taxes?
If you are not deducting payroll taxes, then you are expected to pay either 100% of last year’s tax or 90% of this year’s bill. The penalty for late payment is usually 0.5% of the unpaid tax for each month or part of the month that is not paid. In addition to the penalty, underpayments are subject to 3% interest for individuals.
The bottom line
If you are interested in making a Roth IRA conversion, be sure to consider your current and future tax implications before making any decisions. If you can cover taxes and think you will be in a higher tax range later, it can make a lot of financial sense. If not, maybe it’s better to leave your money at a traditional IRA.
It is helpful to consult a financial planner or consultant who can help you decide if — and when — a conversion might work for you.