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How to pay taxes on Traditional IRA to Roth IRA conversion?

#1
When one converts from a Tradional IRA to a Roth IRA, is it better to have taxes withheld at time of conversion or to pay taxes the following year with other funds?
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#2
Taxes withheld are treated as if they were withheld the entire year. That may or may not be important to you, depending on whether you would face an underpayment penalty. The federal underpayment penalty is usually not large -- it is more like reasonable loan interest. It can be more severe for some states.
 
So usually it would be better to have the taxes withheld.
 
EDIT...  I had not properly thought through the Roth aspect. Supposing no RMD is needed from the regular IRA, I wonder if this strategy works. Suppose you want to convert 100,000 from IRA to Roth, and you want to withhold $24,000 to the feds and $6,000 to the state. You transfer $30,000 of non-IRA funds to the IRA. You then convert $100,000 to ROTH  You have a $30000 excess contribution. So you remove that $30,000 excess filling out specifying  80% federal withholding and 20% state withholding in section 5. Can  you get away with that?
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#3
Would this be simpler?
  • Convert 100,000 from traditional IRA to Roth IRA

  • Withdraw 24,000 from non-IRA account and send to IRS

  • Withdraw 6,000 from non-IRA account and send to State
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#4
Yes. However that could cause an  under-withholding penalty.
 
Incidentally, Q2 estimated taxes are due June 15.
 
There is a way to avoid or reduce a penalty by figuring which period the income came in. "Annualized Income Installment Method". However this is harder than it sounds. I did it once.You not only  break up the income into periods, you have to break up deductions into periods. And I think there was a third thing you had to break up. When I did this in Turbotax, this came as a surprise after I had entered the income pieces. But by that time I had already put considerable work into the process (I am not efficient), I felt invested. I think I saved about $15 by that method. I resolved to not be in that situation again.
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#5
Yes, it makes perfect sense to fund the withholding tax with pre-tax dollars (preferably cash, or traditional IRA/before-tax if short of cash). However, it is important to note that even if you made "estimated tax payments" at the time of conversion, you better file Form 2210 with your federal tax return - my tax software warned me when I prepared my return, and I foolishly left it up to the IRS to figure it out. They sent me an underpayment penalty notice!

I went back to my tax software and hashed out Form 2210 to "prove" to IRS that I should not be liable for any penalties. The reason why I did not try to complete Form 2210 during my initial filing was to avoid the hassle of figuring out the "quarterly" income amounts and tax liabilities - I am retired and have minimal "earned income", so the bulk of my AGI was from a single Roth conversion in December when I also made direct estimated tax payments to the IRS - thinking that I was following the "pay as you go" guideline in good faith. I suppose the computer algorithms used by the IRS are biased towards maximizing your tax owed!
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#6
(11-21-2018, 05:53 PM)vivian Wrote: Would this be simpler?
  • Convert 100,000 from traditional IRA to Roth IRA

  • Withdraw 24,000 from non-IRA account and send to IRS

  • Withdraw 6,000 from non-IRA account and send to State

ABSOLUTELY THE ONLY CORRECT WAY TO DO!!
ALWAYS CONVERT THE GROSS AMOUNT!
AND PAY TAXES FROM A NON IRA TAXABLE ACCOUNT!!
 
Otherwise one defeats the purpose and advantage of the conversion!
 
It is amazing how many professionals at the big firms consistently blunder here by only moving the estimated after tax amount to the Roth IRA.
 
The professionals leave it to their back office who confuse a ROTH CONVERSION with a Required Minimum Distribution from a traditional IRA to a TAXABLE account.
 
While a Roth Conversion is FROM a traditional IRA to a ROTH IRA
 
Two different animals
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#7
So what if you don't have enough taxable-account money to pay the taxes?  Is there any benefit to converting other than to possibly pay taxes in a lower bracket than you might be in when you start taking RMDs?
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#8
(12-17-2018, 08:24 AM)Omy Wrote: So what if you don't have enough taxable-account money to pay the taxes?  Is there any benefit to converting other than to possibly pay taxes in a lower bracket than you might be in when you start taking RMDs?

Personally, I think conversions (and paying taxes from the proceeds) may still be worthwhile by providing flexiblity and tax planning opportunities for the future.
Consider:
1) Roth IRAs do not have RMDs for either the owner or their spouse/survivor.
2) Unlike T-IRA RMDs or withdrawals, Roth withdrawals are never considered as taxable income and are not included in MAGI calculations for SS taxation or medicare premium calculations.  
3) Unlike T-IRAs, heirs would not owe any taxes on inheriting a Roth IRA.
4) If you are MFJ and one of you dies, T-IRA RMDs, the compression of the tax brackets (single) and the $10K drop in the standard deduction may push the survivor into a higher tax bracket.   Not true for Roth IRA funds.
5) Think like a farmer.  Sometimes, it is easier to pay tax on the seed (conversion amount) rather than then paying tax on the  harvest (what the non-converted T-IRA may grow to) without being pushed up into a higher tax bracket.
Personally, I look at Roth conversions as a way to "even out" my taxable income and eventual (MFJ and single) tax brackets while providing future (taxable vs non-taxable) realized income flexibility. 
 
Other than a drop in your tax rates or a drop in the value of the assets converted, it may be hard to find a situation where Roth conversions don't at least break-even.  
Others have different perspectives.
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#9
(12-17-2018, 08:24 AM)Omy Wrote: So what if you don't have enough taxable-account money to pay the taxes?  Is there any benefit to converting other than to possibly pay taxes in a lower bracket than you might be in when you start taking RMDs?

To answer your question:
1. You may be limited then unless you wanted to borrow or steal the money for taxes at say a lower percentage??
Is risky of course like buying on margin.
 
Convert a smaller amount for which you do have the cash to pay taxes?
Having a Traditional IRA only (And no taxable account) actually is not a very good deal because of the income rate taxes on Cap Gains and Dividend.
In the long term and with the right investment you should be able to average at least 8% to 10% average annual return. Assuming you do know what you are doing when investing.
Keep in mind the conversion only pays off when the investment goes up
 
But you never should pay taxes out of the conversion amount. (Besides at conversion time you really do not know exactly what the taxes are. You just make a guesstimate based on what you think your marginal bracket will be.
 
Let's assume you know the exact amount of taxes on the conversion. Then do a simulation in a spreadsheet over say 10 years for a tax free Roth and for proceeds from a Traditional IRA taxed at your marginal income rate.
Also account for the taxes paid with the conversion that could have been invested.
Use the same virtual investment and the same rates of return. You will find that you will be ahead with the Roth if your investments go up over time. which over the long term most likely do as long as you don't panic.
Now if you need the money in two years forget about it of course. Think 5 or 10 years or more.
 
2. Everyone's financial situation is different of course. So one has to look at the whole picture.
Another factor in my case was that in 20 years of retirement I ended up in a much higher tax bracket than while working! So on the traditional IRA distributions I now pay more taxes than I saved when contributing.
And only getting worse over time. Seems a good reason for a Roth Conversion.
 
Now if one is in a much lower tax bracket now than when contributing it may or may not make sense to convert. Only you can tell.
What one can do is when one still is halfway e.g. a lower bracket (e.g. 10%)  look at how much room is left before hitting 25% tax bracket. Can be advantageous when retired and 65 with Social Security postponed until 70 when one can end up in 25% bracket for example. You have to analyze your own situation.
 
3. Another factor could be Estate planning. One never ever pays taxes on a Roth and neither do beneficiaries! For those who do not need the IRA's after all. (But as far as I know Beneficiaries do have to take RMDs albeit tax free. This game does not carry over to grandchildren )
 
4. Do some careful planning. As far as RMDs look at the numbers and total picture. Your income, tax bracket and whether you need the money. Your life expectancy etc. I always look at the opportunities an investment opportunity presents. Taxes on RMDs are my lesser worry.
The higher income and tax bracket and the less you need the money and the more extra cash for taxes one has the more beneficial a Roth Conversion can be. But you don't know until you do the numbers for your specific case.
 
Quicken Pay financial software used to have a great financial planning tool. Used it extensively before retiring.
After 20 years my Roth is by far my best performing investment followed by taxable account and Traditional just in third place (thanks to RMDs)
Hope this helps a bit.
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#10
I do quarterly estimated tax payments. If you elect not to do quarterly taxes, it may be in your best interest to have Fidelity do the withholding.
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