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 avoid the tax consequences of a Roth conversionit is useful 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 bill is paid when you start withdrawing money pension. 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.)
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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 the fees income taxs 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.