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Ways to pay Roth IRA conversion taxes

Bull bear stock market

The market is still volatile, dropping a bit today because … heck, who really knows exactly why this time?

It's likely to keep bouncing a bit until the current and threatened trade wars and associated tariffs are resolved.

I definitely am not a financial adviser, but even I know that you shouldn't try to time the stock market. Just when you think you've hit the bottom and cashed out, it drops more. Or it recovers and you miss a run back up that would have replaced (or more) your assets' losses.

But if, after careful consideration and consultation with your personal tax and financial folks, you might decide it is time to make a move that is financially and tax advantageous in a down market.

I'm talking about converting a traditional individual retirement arrangement (IRA) to a Roth IRA.

Why a Roth? Roth IRAs have several advantages.

There's no required minimum distribution (RMD) rule.

You can keep contributing to your Roth after age 70½ as long as you meet the income guidelines.

Best of off, distributions from a Roth IRA are tax free.

The cost of conversion: The one downside of converting to a Roth is that you must pay tax on the traditional IRA money that was tax deferred.

That's where a slumping market comes into play.

As I noted in my earlier post on how stock losses can help cut your taxes, when a down market means the value of your traditional IRA has dropped, you owe less tax on the converted amount.

Even then, though, the tax might be a challenge.

Here are four options suggested by the investment management firm T. Rowe Price that could help in dealing with the traditional-to-Roth conversion taxes.

1. Stagger the conversion. If a Roth IRA conversion would push you into a higher federal tax bracket, consider conducting multiple partial conversions over a period of a few years.

2. Use taxable money to pay. Generally speaking, it’s ideal to pay taxes on the conversion from a taxable account. This method may have the smallest tax consequences.

3. Make a tax-free Roth withdrawal. If you don’t have enough savings in a taxable account to pay the taxes, consider taking a tax-free withdrawal from an existing Roth IRA. Note that for those under age 59½, only contributions can be taken tax-free. Generally, if you’re age 59½ or older and have held the account for at least five years, however, you can take tax-free withdrawals of both contributions and earnings.

4. Tap your traditional IRA. If neither a taxable account nor an existing Roth IRA is available to pay the taxes, you can consider withdrawing from a traditional IRA. One consequence is that this would result in additional taxes on the amount you withdraw to pay the conversion taxes. And if you tap in to the traditional IRA when you're younger than age 59½, your withdrawal will be subject to a 10 percent early withdrawal penalty.

Of course, as with all things and especially all things tax, there are pros and cons. Weigh your options, talk with professionals and choose the move that's best for you, your retirement savings and your taxes.

IRA nest egg

Comparing IRAs: The table below also can help you decide not only whether to convert, but which IRA is better for your personal circumstances.

COMPARING IRAS

Both Traditional IRAs and Roth IRAs offer unique tax advantages. 
With a Traditional IRA, you have to start taking required minimum distributions (RMDs)
from the account each year once you reach age 70½.
Since this withdrawal amount generally is treated as ordinary income,
you may be obligated to pay taxes on withdrawals.
With a Roth IRA, there are no RMDs, and you can make qualified withdrawals without paying taxes.

 

Traditional IRA

Roth IRA

Taxes on withdrawals

Withdrawals of pretax contributions and earnings are taxed as ordinary income

Withdrawals of contributions and converted assets are tax-free. Generally, withdrawals of investment earnings are also income tax-free if:

-- you've held the account for at least five years, and

-- you are age 59½ or older

Required minimum distributions (RMDs)

Must take your first RMD by April 1 of the year after the year you turn age 70½ 

None

Early withdrawal penalties

Withdrawals of contributions and earnings prior to age 59½ may be subject to a 10% penalty (with some exceptions)

Withdrawals of earnings that are not qualified distributions* may be subject to a 10% penalty (with some exceptions). Withdrawals of converted assets may be subject to a 10% penalty (with some exceptions) before the converted account is five years old.

Advantages1

-- Tax-deferred potential growth

-- Tax-deductible contributions (when applicable)

-- Tax-deferred potential growth

-- Tax-free qualified withdrawals

-- No RMDs

-- Heirs can take potentially tax-free withdrawals from Inherited Roth IRAs

Considerations

-- Withdrawals of pretax contributions and earnings are taxed as ordinary income

-- RMDs begin at age 70½

-- Contributions are not tax-deductible

-- Heirs must take RMDs

Spousal beneficiaries2

Subject to RMD rules

No RMDs

Non-spousal beneficiaries

Non-spousal beneficiaries can take distributions from an Inherited IRA before age 59½ without incurring the 10% early withdrawal penalty. They also can designate their own beneficiaries for the Inherited IRA.

1Subject to phase-out based on IRA owner’s modified adjusted gross income for deductibility to a Traditional IRA or for contributions to a Roth IRA.

2If spouse elects to treat the Inherited IRA as his/her own.

*A qualified distribution is tax-free if taken at least five years after the year of your first Roth contribution and you’ve reached age 59½, become totally disabled, died, or met the requirements for a first-time home purchase.

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Comments

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Jack Quattlebaum

Thank you, Kay! I read your blog daily and find it very informative. This topic is of particular interest to me.

I plan to use #1 Stagger the conversion - choosing a conversion amount which will also keep me below the $170k IRMAA limit to avoid paying additional Medicare premiums.

I prefer #2 Use taxable money to pay - the unasked/unanswered question is: How to make this payment.

I am having taxes withheld from my monthly RMD payments to avoid filing quarterly returns, but since my planned partial conversion in December after my final RMD payment will increase my tax liability beyond even my safe harbor, I plan to submit the additional tax as a Q4 estimated tax payment.

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