I want to do a Roth conversion from my traditional IRA for $250,000. I understand that I will have to pay income tax on the $250,000. Can that tax be paid from the funds in the IRA or do I have to pay the tax outside the IRA?
– Kevin
This one is simple. The tax authorities don’t care where the money comes from. As long as you give them a check, they’ll be happy!
All kidding aside – yes, the $250,000 is included in your gross income. You can pay the tax bill with the converted money or with money from other sources, but the difference is potentially significant. You may want to consider using non-IRA funds to pay the tax bill if this is an option for you.
A financial advisor can help you make important retirement planning decisions, such as when to make a Roth conversion and for what amount. Contact a financial advisor.
To understand the tax implications of a Roth conversion, it’s helpful to think about what this type of transfer does. A Roth conversion allows you to transfer money from a traditional, tax-deferred retirement account to a Roth IRA.
The main idea behind tax-deferred retirement accounts is in the name. When you contribute to a traditional IRA, 401(k) or similar account, you are allowed to deduct that amount from your current gross income, thereby avoiding tax liability for that year. Instead, that tax liability is deferred until you withdraw the money from the account. This deferral also applies to the growth, dividends and interest that the money produces.
Normally this tax assessment is due when you retire. However, if you move that money to a Roth IRA, it will also be removed from the account, causing you to be charged income taxes. Assuming you made deductible contributions (not non-deductible contributions) to your IRA, the converted funds will be added to your gross income for the year and your tax liability will increase. (A financial advisor with tax planning expertise can be a valuable resource when making important financial decisions, especially around retirement.)
A Roth conversion is a common retirement planning maneuver, but triggers a tax bill in the year it is completed.
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You can pay the tax bill on a Roth conversion with part of the converted balance or money you have outside your IRA. Here’s a closer look at the two options:
In practice, many people rely on the converted money to pay income tax on the conversion. If you don’t have money to cover taxes outside of the IRA, this may be your only option. If that’s the case, you can normally have the financial institution withhold the money when they make a conversion.
If you have enough savings outside of your IRA to pay the tax bill, this is almost always the better option from a retirement savings perspective. By taking this approach, you will not only avoid potential tax penalties associated with using the converted money to pay your taxes, but you will also ensure that the entire converted balance ends up in your Roth account tax-free. Of course, make sure you don’t deplete your emergency savings.
For example, let’s assume someone in the 24% marginal tax bracket has $100,000 in sales and $24,000 in cash that they can use to pay their tax bill:
If they pay the tax bill with the converted money, they will be left with only $76,000 after taxes in their Roth IRA, along with their $24,000 in a taxable savings or brokerage account.
If they use the savings to pay the tax bill, the entire $100,000 would go to the Roth IRA.
The big difference is in how the two accounts are taxed. Because Roth IRAs grow tax-free, it’s much more efficient to maximize savings there, especially if you plan to invest that money for a while. (Consider a match with a financial advisor if you need help tackling retirement planning scenarios like these.)
If you have not yet reached the age of 59.5, it is important to take into account the 10% early withdrawal penalty. This penalty does not apply to the conversion itself, but it does apply to any amount you withdraw to pay tax. This makes paying the conversion tax with savings even more valuable if you are under 59 ½ years old.
Additionally, the penalty applies regardless of whether you withheld some of the money for taxes at the time of the conversion or whether you withdraw the money from your Roth IRA when you file your taxes. If you withdraw these funds less than five years after a conversion, you will violate the five-year rule for Roth conversions and will be charged a 10% early withdrawal penalty if you have not yet reached age 59.5. (This five-year rule can be confusing, but a financial advisor can help you navigate it and avoid potentially expensive tax penalties.)
A man is considering the best way to pay the tax bill on his Roth conversion.
You can pay the tax bill on a Roth conversion from any source. You can have part of the conversion withheld; you can wait until tax time and withdraw from the Roth balance; or you can use external savings to cover the tax debt. Keep in mind that early withdrawal penalties may apply if you use IRA money to pay the tax bill. If you are able to do so, paying with foreign dollars is usually the much better option.
Hiring a financial advisor isn’t just about finding someone who can get the greatest return on your investment. That’s important, of course, but you should also try to work with an advisor whose services and specialties match your needs. For example, if you need help organizing your estate and creating a plan for how to pass on your assets in a tax-efficient manner, you will want to find an advisor who offers estate and estate planning services . After all, not all advisors are specialized in these fields.
Finding a financial advisor does not have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can have a free introductory meeting with your advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
Are you a financial advisor looking to grow your business? SmartAsset AMP helps advisors connect with leads and provides marketing automation solutions so you can spend more time making conversions. Learn more about SmartAsset AMP.
Brandon Renfro, CFP®, is a financial planning columnist at SmartAsset, answering reader questions about personal finance and tax topics. Do you have a question that you would like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column. Some reader-submitted questions have been edited for clarity or brevity.
Please note that Brandon is not a participant in the SmartAsset AMP platform, is not an employee of SmartAsset, and has received compensation for this article.
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