I want to do a Roth conversion with $250,000 from a traditional IRA. It is my understanding that I owe income tax on the $250,000. Can that tax be paid from the funds in the IRA or do I have to pay taxes outside the IRA?
– Kevin
This one is straightforward. The IRS doesn’t care where the money comes from. As long as you cut them a check, they’ll be happy!
All jokes aside – yes, the $250,000 is included in your gross income. You can pay the tax bill using the converted money or money from other sources, but the difference is huge. If that’s an option for you, you might consider using non-IRA funds to pay the tax bill.
To understand the tax implications a Roth conversionIt is important to think about what this type of transfer does. A Roth conversion allows you to move money from a traditional, tax-deferred retirement account to a Roth IRA.
The main idea behind tax-deferred retirement accounts is the name. When you contribute to a traditional IRA, 401(k) or similar account, you can deduct that amount from your current gross income, thereby avoiding tax liability for that year. Instead, that tax liability is delayed until you withdraw the money from the account. This deferral also applies to growth, dividends and interest earned by the fund.
Typically, this tax refund payment comes when you start withdrawing. Retirement. But rolling the money over to a Roth IRA removes it from the account, triggering income taxes. Assuming you made deductible contributions (non-deductible contributions) to your IRA, the converted funds will be added to your gross income for the year and increase your tax liability. (A Financial advisor Tax planning knowledge can be a valuable resource when making important financial decisions, especially during retirement.)
A Roth conversion is a typical retirement plan, but it triggers a tax bill in the year it’s completed.
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In a Roth conversion, you can pay the tax bill using the converted balance or money outside of the IRA. Take a closer look at the two options:
As a practical matter, most people rely on currencies to pay. Income taxOn conversion s. If you don’t have money outside of an IRA to cover the tax, this may be your only option. If that’s the case, you can have the financial institution hold the money during the exchange.
If you have enough savings outside of an IRA to pay the tax bill, this will always be the best option in terms of retirement savings. By following this approach, in addition to avoiding tax penalties associated with using the converted funds to pay taxes, you ensure that the converted balance grows tax-free in your Roth account. Of course, be careful not to exhaust yours Emergency savings.
As an example, let’s say someone in the 24% marginal tax bracket is turning over $100,000 and has $24,000 in cash, which they can use to pay their tax bill:
If they pay the tax bill using the converted money, they will have only $76,000 left in the Roth IRA after taxes, with $24,000 in a taxable savings or brokerage account.
If you use the savings to pay off the tax bill, the entire $100,000 goes into the Roth IRA.
The biggest difference comes in the way the two accounts are taxed. Because Roth IRAs grow tax-free, they’re more efficient at maximizing savings, especially if you plan to invest the money over a period of time. ( look out Matching with a financial advisor (If you need help resolving such retirement plan situations.)
If you are under 59 ½, it is important to consider. 10% early withdrawal penalty. The change itself isn’t subject to this penalty, but any amount you took to pay taxes is. This makes it more beneficial to pay the conversion tax with cash savings if you are under 59 ½.
In addition, the penalty applies if you have a portion of the money withheld for tax at the time of the conversion, or if you withdraw the money from your Roth IRA when you file taxes. Withdrawal of these funds in less than five years after conversion Five-year rule on Roth conversions And it triggers a 10% early withdrawal penalty if you’re under 59 ½. (This five-year rule can be confusing, but a Financial advisor It can help you navigate it and avoid costly tax penalties.)
One thinks of the best way to pay one’s tax bill on a Roth conversion.
On a Roth conversion, you can pay the tax bill from any source. You can block a part of the conversion; You can wait until tax time and withdraw the balance from the Roth; Or you can use foreign savings to cover tax debt. Keep in mind that there may be early withdrawal penalties if you use IRA funds to pay the tax bill. Paying in foreign dollars is a much better option if you can.
Hire a financial advisor It’s not just about finding someone who will get the most return on your investment. That’s important, but you should look to work with a consultant whose services and areas of expertise match your needs. For example, if you need help organizing your estate and planning how to transfer your wealth in a tax-efficient way, you’ll want to find an estate and property advisor. Heritage planning Services. After all, not all consultants specialize in these areas.
Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool Matches up to three qualified financial advisors You can schedule a free introductory call with your advisor to determine which ones serve your area, and which one you feel is right for you. If you are ready Find a counselor Who can help you achieve your financial goals? Start now.
Keep an emergency fund handy in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t exposed to high volatility, like the stock market. The trade-off is because the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
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Brandon Renfro, CFP®, is a financial planning columnist for SmartAsset and answers reader questions on personal finance and tax topics. Have a question you want 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 is being compensated for this article.
