Estimated Taxes and Roth IRA Conversions
How many times have you gotten a gift from the IRS? In 2010, though, Americans saving for retirement in a Traditional IRA because their income was too high to contribute to a Roth IRA, got a big one.
Traditional IRA to Roth IRA conversions used to have an income cap. If you earned more than $100,000 per year you were not allowed to convert your Traditional IRA to a Roth. Now high earners can. Whatâs now allowed is essentially sneaking in through the back door: You contribute to a Traditional IRA, then immediately convert it to a Roth.
But thereâs another aspect of converting to a Roth that isnât discussed as much. Converting can be massively pricey. Hereâs what you need to know about the costs of converting.
Paying IRA Conversion Tax
When you make the conversion from a tax-deductible IRA to a Roth the amount you convert is added to your gross income for that tax year. It increases your income and you pay your marginal tax rate on the conversion.
If youâre in the 25% tax bracket and convert $20,000, your income will increase on that yearâs taxes by $20,000. Assuming this doesnât push you into a higher tax bracket you will need to pay $5,000 in tax to the government to convert.
Be careful, here. Donât take the $5,000 out of your account from the conversion. Youâll lower your retirement balance by $5,000. Lowering your balance that much can cost you thousands of dollars in growth until retirement. Save up cash in a savings account to cover your conversion taxes and donât touch the amount you convert.
Donât Wait All Year to Pay
Another facet of conversions that isnât talked about a lot is estimated taxes. Most individuals pay their income tax to the government with every paycheck. Itâs automatically removed based on the withholdings you claim on Form W-4. As the year goes on your taxes are paid for you. You donât have to write a separate check to the government until you file your taxes, and in that case only if you didnât have enough money taken out and you still owe.
But small business owners and corporations are familiar with estimated taxes. Each quarter these entities estimate how much tax they will owe based on their income and expenses. At a predetermined date the tax is paid to the government. (Itâs usually the 15th of April, June, September and January of the following year.)
Why is this important to note? If you convert a substantial Traditional IRA to a Roth IRA in the first quarter of the year, your quarterly income and quarterly tax increases greatly. In our example above if you had a $5,000 increase in your taxes in the first quarter, you need to pay them on April 15th. Not paying them until the end of the year or when you file your taxes will result in penalties and interest.
Safe Harbor Rules
For those used to paying estimated taxes, you may be wondering about safe harbor rules. For the uninformed, safe harbor rules mean that if you pay at least 100% (or 110% depending on the situation) of your previous yearâs taxes in estimated taxes this year, you wonât pay any fees or interest by underpaying.
This is to protect individuals or businesses whose income may skyrocket thanks to a great year following a really poor year. As long as youâve paid at least as much as you did last year, you are pulled into the âsafe harborâ and donât have to worry about interest and fees.
This is where things can get sticky, and you need to talk to a tax advisor. At the end of the day, if you just pay your estimated taxes you donât have anything to worry about. If you end up paying too much into the tax system, youâll get a refund when you file your taxes at the end of the year. Think of it as a sanity payment.
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