Roth IRA Conversion Income Tax Implications
Should You Withhold Income Taxes on a Roth Conversion?
Converting your pre-tax retirement account balances to Roths can effectively position you for a tax-efficient retirement. Taking advantage of the retirement income gap or lower earnings years to make these conversions can be an excellent strategy. However, you should consider the tax implications.
When performing a Roth conversion, you may be confronted with the decision to withhold income taxes from the amount being converted. This decision can be complex and depends on various factors, including your current financial situation, income tax brackets, and long-term financial goals.
(Note: This article is not about after-tax Roth conversions, commonly called backdoor Roth conversions. This article discusses plain old vanilla pre-tax traditional IRA balances converted to Roth accounts.)
What are the income tax implications of a Roth conversion?
Converting funds from a Traditional IRA to a Roth IRA is considered a taxable event. This means the amount you convert will be treated as ordinary taxable income in the year the conversion occurs. You will be issued a 1099-R, which will report to the IRS exactly how much was converted and how much of the conversion is taxable. The taxable amount must be reported on your income tax return, which could push you into a higher income tax bracket.
Should I withhold income taxes on my Roth conversion?
When processing the conversion, you will be asked if you would like any amount to be withheld for the payment of income taxes. If you confirm you would, these amounts will be subtracted from the converted amount, and the net amount will be transferred to the Roth IRA.
For example, let's say you convert $50,000 and direct your custodian to withhold 30% for the Feds and 10% for California. This conversion would result in $50,000 in taxable income, with $15,000 sent to the Feds and $5,000K to CA. Only $30,000 would land in the Roth and then be able to grow tax-free.
What happens if I do not withhold income taxes on my Roth conversion?
Using the example above, let’s assume you do not withhold income taxes on the conversion. In this scenario, you will transfer all $50,000 to the Roth IRA. However, you will still have an additional $50,000 in taxable income and need an extra $20,000 in cash to cover the related taxes. The benefit of this structure is that all $50,000 was transferred to the Roth IRA, where it will grow and be distributed tax-free.
What are the things I should consider when making a Roth conversion?
1. Tax Implications: If you plan to convert a substantial amount, you should complete a detailed income tax projection. An income tax projection will calculate your estimated income tax on all activity during the year, including the substantial Roth IRA conversion. This projection will help illustrate the related implications of the conversion so you can plan accordingly.
2. Withholding Taxes vs. Making Estimated Payments: While withholding income taxes on the conversion may be more convenient, making estimated tax payments or covering the related taxes with cash outside the retirement accounts will help ensure the largest amount of money is transferred to the Roth IRA. Once in the Roth, the more significant amount will be allowed to compound and grow tax-free.
3. Available Cash: If you do not withhold on the conversion, you will need additional cash outside the retirement accounts to make the related income tax payments. Make sure you have sufficient cash so you do not dip into your emergency fund or be forced to sell other investments, which couple trigger additional income taxes.
4. Timing of the Conversion: If you convert early in the year, you will have more time to adjust your wage withholdings or make estimated tax payments, if needed. If the conversion happens later in the year, you might have fewer options and less time to compensate for the taxes due.
In summary, withholding income taxes during a Roth Conversion can be a good idea if you want to ensure that you have enough funds to cover the tax liability and don't want to give much thought to the process. However, paying taxes outside the conversion is a great way to maximize the amount transferred into the Roth IRA.
Ultimately, it's important to carefully calculate and consider the implications based on your financial circumstances and long-term goals. Before making decisions regarding Roth conversions and income tax withholding, consult your financial advisor and tax professional.
About the author:
JP Geisbauer is a Certified Public Accountant, a Certified Financial Planner ®, and the founder of Centerpoint Financial Management, LLC, a financial planning, investment management, and income tax planning firm located in Irvine, CA. JP Geisbauer is dedicated to helping California-based business owners and executives transition into retirement. He has been quoted in many news outlets including Forbes, Newsweek, US News & World Report, MarketWatch, YahooFinance, CNN and NerdWallet.
Need help with your transition into retirement? Schedule a complimentary 30-minute call with JP here.
Disclaimer:
This article is for general information and educational purposes only. Nothing contained in this article constitutes individual financial, investment, tax, or legal advice. Before taking any action on any topic discussed in this article, consult with your own financial planner, investment advisor, tax professional, and/or attorney for advice on your specific situation.