Roth Conversion
I wish to convert an IRA to a Roth in 1/2010 of say 100,000. Estimate of taxes 20,000 payable over two years. Can I make a withdrawl from the Roth at 10,000 per year prior to 4/15/2011 for the 2010 taxes and 4/15/2012 for the 2011 taxes, to pay these taxes? Thanks Roy Williams
Permalink Submitted by mk foss on Thu, 2009-08-27 22:07
Yes, you can make withdrawals to pay the taxes. The first funds that come out of a Roth IRA are after-tax contributions, then Roth conversions and finally earnings.
There would be no income tax on the withdrawals because of the 100k initial conversion amount. If you are under 59.5 when you make the conversion, there would be a 10% penalty on the withdrawals. That’s the 10% penalty you avoided by converting the IRA to Roth rather than withdrawing it.
Of course, you get the best benefits from the Roth if you don’t need to tap it to pay the taxes.
Permalink Submitted by Alan Spross on Thu, 2009-08-27 22:31
Roy,
You can do that, however there is a provision under which distributions of the actual 2010 conversion dollars prior to 1/1/2012 will accelerate the reporting of taxable income into the year of the distribution. If your Roth distribution comes from previous regular or conversion amounts, then your taxable income is not accelerated. However, using your example and assuming that the 2010 conversion is your first Roth contribution of any type, here is what would happen:
1) Convert 100,000 in 2010
2) In 2011 you must decide to defer the conversion taxes to 2011 and 2012 or opt out and report the conversion in 2010. You select the default method of deferral.
3) Let’s assume you take $10,000 of distributions in 2011 to pay your estimated taxes on the conversion to avoid an underpayment penalty for 2011. This will cause an ADDED $10,000 of income from the conversion to be included with your 2011 income. Now you have taxable income of $60,000 in 2011 and $40,000 in 2012 instead of $50,000 in each year. The added $10,000 of income in 2011 would produce additional taxes in the 20% bracket of $2,000. So you are still $2,000 short of paying your tax bill. These accelerations are always taken from the 2012 income amount first and accelerated into the year you took the distribution. If you took the distribution in 2010 after doing the conversion, it would accelerate the 2012 share to 2010.
There is also the potential 10% early withdrawal tax if the distribution of conversions held under 5 years was done prior to age 59.5 as indicated by Mary Kay.
This becomes even more complex if your Roth conversion was less than 100% taxable because you had basis in your TIRA from Form 8606. In that case, you cannot apply any basis to the accelerated income, meaning that the amount added to your 2011 tax bill would be fully taxable even though your original conversion was not.
All this is going to result in some major additional complexity to the 2010- 2012 editions of Form 8606 to accomodate the reporting of these rules. But if you want to keep it simple, plan to be able to pay the conversion taxes from non IRA funds, or at least if they do come from your Roth IRA, that you have enough prior contributions pre 2010 to cover the taxes.
Permalink Submitted by Ed Mangan on Fri, 2009-08-28 18:16
[quote=”[email protected]“][i]I wish to convert an IRA to a Roth in 1/2010 of say 100,000. Estimate of taxes 20,000 payable over two years. Can I make a withdrawl from the Roth at 10,000 per year prior to 4/15/2011 for the 2010 taxes and 4/15/2012 for the 2011 taxes, to pay these taxes? Thanks Roy Williams[/i][/quote]
I think what they are trying to say is. if the $20K comes from the transfered funds it is
taxable @ 10% penalty if under 59 1/2. over that age I’m not sure.
however if you already have money in the roth like you put in the $20K cash earlier.
you could withdraw that and use it to pay the taxes, penalty and tax free.
if you already invested just $10,000 cash in the roth years earlier, then you could
use that much 10% penalty free/tax free.
and then come up with the other $10,000 from out of pocket.
or split that over the two years for payment.
hope that helps.
Permalink Submitted by george collins on Fri, 2009-08-28 18:36
Help—-I Don’t appreciate the tax deferred part of the one time 2010 conversion option.
For example, if I convert 150k (to stay in the same marginal tax rate) in 2010 and pay taxes in 2011 and 2012, I will pay the same tax over 3 years at 50k converted/yr. I appreciate the time value of money, but is this the only benefit? My rough calculations show about a 2k benefit over the annual 50K conversion. This verses future tax increases may be at least a wash or even a loss.
My financial plan is to convert 500k over the next 5-10yrs.. The tax benefit of minimizing my RMD and delaying SS to 70 is significant. My current plan is convert as much as possible/yr to maintain a constant marginal tax rate.
All advice appreciated
jerry
Permalink Submitted by Alan Spross on Fri, 2009-08-28 20:27
Jerry,
You are correct. In your situation, you plan to convert incremental amounts over a period of years in order to reduce the overall tax cost of the conversions. In that case, you would opt out of the two year deferral, and just convert the incremental amounts each year. If you do NOT opt out, you do not get to use any of your 2010 tax bracket, and the amount deferred would probably limit your additional conversions in 2011 and 2012. If so, by the end of 2012 you would have converted only 2/3 of the amount you would have by doing a conversion each year. Obviously, you would be giving up the advantage of getting in earlier if the investment rose sharply right after the 2010 conversion. This is a take off of the issue of dollar cost averaging vrs a lump sum investment. But there is even a way to hedge against that. You could do a very large conversion in 2010 with the idea of recharacterizing part of it UNLESS the market soars. If the market soared, the gains would more than offset the extra taxes you would pay for spilling over into the next bracket. The recharacterization must be completed prior to 10/17/2011, the same final date for deferring or opting out of the two year deferral.
Permalink Submitted by george collins on Fri, 2009-08-28 20:50
Alan, thanks for the quick answer.
I Like your thought on partial recharacterization as a function of the market.
Do not understand the 2/3’s of the total converted if I do not opt out and use the 2010 conversion. If I take the option and take a 150k-2010 conversion and use 75k in 2011 and 2012, how do I lose the total?
What I also like in the annual option is the ability to reconvert every year.
jerry
Permalink Submitted by Alan Spross on Fri, 2009-08-28 21:05
Example: You can accomodate 75,000 per year added AGI for conversions and remain below the next higher bracket.
1) You convert 150,000 and report 75,000 for 2011 and 2012, but do not use any of your 2010 bracket
OR
2) You want to use your lower bracket each year and therefore convert 75,000 each year and opt out of the deferral. This provides a total of 225,000 in conversions instead of 150,000 (2/3).
You cannot combine these two plans if single, but if married your spouse can make a different decision than you if they have their own IRA. Eg. you defer your 150,000 conversion and spouse adds a 75,000 conversion and opts out by reporting all of it in 2010. As a couple you get 225,000 converted, but still stay out of the higher bracket by using the 2010 bracket for the spouse’s conversion.
Permalink Submitted by george collins on Fri, 2009-08-28 21:22
Alan, crystal clear. I new there was a reason I’ve stayed married. Unfortunately, I already have all of her $$ in a Roth.
I came up with the 150k as I originally planned to convert 50k/yr . 60k/yr (174,650-114,650) is my max without busting into next bracket another 5%.
thanks again.
Permalink Submitted by Alan Spross on Fri, 2009-08-28 21:34
Let’s hope that the 2010 brackets are not adjusted DOWNWARD in October. Someone posed this question on another board, and we will not know for sure until October, although a couple large benefits firms like CCH will publish a very accurate projection next month. The 401k contribution limits are expected to DROP by 500 for 2010. If it happens, it should just be a small adjustment, but if you factored in the usual increase, that will not come to pass for 2010.
Permalink Submitted by george collins on Fri, 2009-08-28 21:46
Let’s see, I can here Obama now. No tax increase, we are just REDUCING the tax bracket. Hope he does, that should kill his party for another 10yrs.
jerry
Permalink Submitted by Alan Spross on Fri, 2009-08-28 22:37
Actually, the tax law is already in place determining which period and which of the various inflation measures are to be used by the IRS. Congress would have to act to change the current law. However, certain groups will probably appeal to their Congressman for some legislative relief and next year is an election year again, so who knows what will happen. Prior Congresses have shown little regard for the IRS need to meet printing deadlines for tax forms.