I want to do a Roth conversion from my traditional IRA in the amount of $250,000. My understanding is that I have to pay income tax on the $250,000. Can this tax be paid from IRA funds or do I have to pay the tax outside of the IRA?
– Kevin
This one is simple. The IRS doesn’t care where the money comes from. As long as you write them a check, they will be happy!
All joking aside, yes, the $250,000 is included in your gross income. You can pay the tax bill using either the converted funds or money from other sources, but the difference is potentially substantial. You may want to consider using non-IRA funds to pay the tax bill if that’s an option for you.
To understand the tax implications of a Roth Conversionit’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 can deduct that amount from your current gross income, thereby avoiding tax liability for that year. Instead, this tax liability is deferred until you withdraw the money from the account. This deferral also applies to the growth, dividends and interest the money earns.
Typically, this tax bill comes due when you start making withdrawals retirement. However, rolling that money into a Roth IRA also removes it from the account, triggering income taxes. Assuming you made deductible (not non-deductible) contributions to your IRA, the converted funds are added to your gross income for the year and increase your tax liability. (A financial advisor Tax planning expertise can be a valuable resource when making important financial decisions, particularly regarding retirement.)
A Roth conversion is a common retirement planning maneuver, but it triggers a tax bill in the year in which it is completed.
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You can pay the tax bill on a Roth conversion using part of the converted balance or money you have outside of your IRA. Here’s a closer look at both options:
In practice, many people rely on converted funds to pay the income taxs on the conversion. If you don’t have money outside of the IRA to cover taxes, this may simply be your only option. If this is the case, you can normally ask the financial institution to hold the money upon conversion.
If you have enough savings outside of your IRA to pay the tax bill, that will almost always be the best option from a retirement savings standpoint. By taking this approach, you will not only avoid the potential tax penalties associated with using converted funds to pay your taxes, but you will also ensure that the entire converted balance grows tax-free in your Roth account. Of course, be careful not to exhaust your emergency savings.
As an example, let’s say someone in the 24% marginal tax bracket converts $100,000 and has $24,000 in cash they can use to pay the tax bill:
If they pay the tax bill using the converted funds, they’ll only be left with $76,000 in their Roth IRA after taxes, plus their $24,000 in a taxable savings or brokerage account.
If they use the cash savings to pay the tax bill, the entire $100,000 would go into the Roth IRA.
The big difference is how the two accounts are taxed. Since Roth IRAs grow tax-free, it’s much more efficient to maximize savings there, especially if you plan to invest the money for a while. (Consider connection with a financial advisor if you need help approaching retirement planning scenarios like this.)
If you have not yet reached the age of 59½, it is important to consider the 10% early withdrawal penalty. The conversion itself is not subject to this penalty, but any amount you withdraw to pay taxes will be. This makes paying conversion taxes with cash savings even more valuable if you’re under 59½.
Additionally, the penalty applies if you have any of the money withheld for taxes at the time of the conversion or if you withdraw the money from your Roth IRA when you file your taxes. Withdrawal of these funds less than five years after a conversion violates the five-year rule on Roth conversions and triggers the 10% early withdrawal penalty if you have not reached age 59½. (This five-year rule can be confusing, but a financial advisor can help you navigate this and potentially avoid costly tax penalties.)
A man considers 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 refuse part of the conversion; you can wait until tax time and withdraw from the Roth balance; or you can use outside savings to cover the tax liability. Keep in mind that early withdrawal penalties may apply if you use IRA funds to pay the tax bill. If you are able, paying with outside dollars is usually the much better option.
Hire a financial advisor it’s not just about finding someone who can get the best return on investment. This is important, of course, but you should also consider working with an advisor whose services and specialty areas match your needs. For example, if you need help organizing your estate and developing a plan for how to pass on your wealth in a tax-efficient manner, you will want to find an advisor who offers estate services and inheritance planning services. After all, not all advisors specialize in these areas.
Finding a financial advisor doesn’t have to be difficult. The free SmartAsset tool connects you with up to three approved financial advisors that serve your area, and you can have a free introductory call with your advisor to decide which one seems best for you. If you are ready to find an advisor who can help you achieve your financial goals, start now.
Keep an emergency fund on hand in case you face unexpected expenses. An emergency fund should be liquid – in an account that doesn’t have the risk of large fluctuations like the stock market. The tradeoff is that the value of cash can be eroded by inflation. But a high interest account allows you to earn compound interest. Compare the savings accounts of these banks.
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Brandon Renfro, CFP®, is a financial planning columnist for SmartAsset and answers reader questions on topics related to personal finance and taxes. Do you have a question you would like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column. Some reader-submitted questions are edited for clarity or brevity.
Please note that Brandon does not participate in the SmartAsset AMP platform, is not an employee of SmartAsset, and was compensated for this article.
