Taxes on IRA Withdrawals and Conversions

[KingB]

I am thinking of rolling over my 401K into an IRA. From the IRA, I want to make withdrawals to cover expenses and also convert some funds into a Roth IRA.

How are taxes handled when:
1. You make the withdrawal.
2. You do a Roth IRA conversion.

 

[GrayHare]

For both you will receive a Form 1099-R representing the IRA withdrawal. For tax purposes the withdrawal amount is considered ordinary income. If you had made non-deductable contributions to your tIRA, those dollars will not be taxed but any earnings on them will (again as ordinary income).

 

[KingB]

How are the taxes paid? Are they taken out of the withdrawals? So, if I want to need 10K, do I request a 10K withdrawal and get the 10K - which means I have to get the taxes from other sources. Or, are the taxes taken out of the 10K?

 

[LOL!]

Taxes can come from either your checking account or be withheld or from your paycheck. You get to decide.

For a conversion, it is best to pay taxes from non-IRA sources such as a taxable account or paycheck. That leaves the most money going to conversion and the least amount of taxes.

 

[dmdunca44]

When I take a withdrawal from my IRA, I have the option of having taxes withdrawn from the funds. I can specifcy the % I want withheld. This is what I usually do. So if I need $10K and want 20% withheld, I request $12,500.

If I wanted to convert $10K to an IRA and pay the taxes from another source, I'd either plan to pay when I file or I'd send in the taxes with the estimated fomr (1040-ES).

Otherwise, the taxes are owed when you file. You do want to be careful that you don't incur a penalty for underwithholding.

 

[Bikerdude]

How are the taxes paid? Are they taken out of the withdrawals? So, if I want to need 10K, do I request a 10K withdrawal and get the 10K - which means I have to get the taxes from other sources. Or, are the taxes taken out of the 10K?

When I make my withdrawals my brokerage custodian asks if I want taxes withheld. I usually decline and make quarterly payments.

 

[Alan]

How are the taxes paid? Are they taken out of the withdrawals? So, if I want to need 10K, do I request a 10K withdrawal and get the 10K - which means I have to get the taxes from other sources. Or, are the taxes taken out of the 10K?

You can choose to have taxes withheld when you make the withdrawals. Those withholding's will show on your 1099-Rs.

 

[GrayHare]

On withdrawals the default is to not withhold taxes, but I believe some IRA custodians will send a 10% withholding to the IRS if you tell them to. With your 1040 filing you'll still need to pay any shortfall. For a Roth conversion you don't actually receive any money in hand, so you need to pay the tax from another source, or withdraw it from the IRA. The latter is typically a poor choice since it reduces your IRA value and may be subject to an early withdrawal penalty.

 

[KingB]

Taxes can come from either your checking account or be withheld or from your paycheck. You get to decide.

For a conversion, it is best to pay taxes from non-IRA sources such as a taxable account or paycheck. That leaves the most money going to conversion and the least amount of taxes.

My plan is to make withdrawals and conversions when I have used my taxable accounts (except for the emergency fund), so the tax money will have to come from the withdrawals. For withdrawals to cover living expenses, I have no choice - I have to do it.

But, for the conversion, I can either forego the conversion or withdraw more funds to cover the taxes. Will there be any advantage of 1 over the other option.

Now, that is the plan when the taxable account run out. But, I still have enough funds to implement your suggestion above. Please explain to me why taking the funds from non-IRA sources will result in the least taxes versus using the IRA money.

Thanks.

 

[RunningBum]

But, for the conversion, I can either forego the conversion or withdraw more funds to cover the taxes. Will there be any advantage of 1 over the other option.

Most people, myself included, think it is to your advantage to keep as much as possible in tax protected accounts. This says that if you have funds outside of retirement to pay the income tax on the conversion, do it that way.

 

[RunningBum]

And as someone already said, paying it through quarterly taxes is the common way to handle this. If you convert in January 2012 and don't pay taxes on this until April 2013, the IRS may charge you interest depending on how significant the amount is to the rest of your income. Maybe even an underpayment penalty.

 

[mickeyd]

Please explain to me why taking the funds from non-IRA sources will result in the least taxes versus using the IRA money.

Since you have already paid taxes on the investment, all that you owe is whatever the investment has grown to less the basis.

 

[LOL!]

....
Now, that is the plan when the taxable account run out. But, I still have enough funds to implement your suggestion above. Please explain to me why taking the funds from non-IRA sources will result in the least taxes versus using the IRA money.

Thanks.

There are lots of ideas and explanations in this thread:
Bogleheads • View topic - How to pay ZERO taxes in retirement with 6-figure expenses

 

[KingB]

Thanks all for the information. I have a lot of work on the spreadsheet to do.

OT or is it? There will be some periods when we start RMD that we will be on the (presently) 25% tax bracket. Would it be wise to up my Roth conversion before RMD so that some of the amounts will be on the 25%.

 

[pb4uski]

All IRA withdrawals are ordinary income.

 

[Gill]

All IRA withdrawals are ordinary income.

...less any pro rated basis.
Bruce

 

[pb4uski]

...less any pro rated basis.
Bruce

Correct, which in my case is zero so I tend to forget about that.

I could never see the attraction of non-deductible IRAs - I preferred taxable investments.

 

[dennygt]

On withdrawals the default is to not withhold taxes, but I believe some IRA custodians will send a 10% withholding to the IRS if you tell them to. With your 1040 filing you'll still need to pay any shortfall. For a Roth conversion you don't actually receive any money in hand, so you need to pay the tax from another source, or withdraw it from the IRA. The latter is typically a poor choice since it reduces your IRA value and may be subject to an early withdrawal penalty.

I just converted a T-IRA to a Roth and had Vanguard withhold taxes. I asked for 15 % Federal and they did. The scary part was the Michigan witholdoing. I asked to withold a specific amount. When I looked at my balances the next day they were less than expected in the Roth; no explanation at all from Vanguard! When I called I found out the state of Michigan changed my withholding to the exact tax liability, to the penny! I was a bit upset that Vanguard didn't let me know, I found out by checking my balances the next day, so BE CAREFUL!

 

[pb4uski]

How would Michigan know your "exact tax liability" until you file your return?

I suppose they figure it is easier for them to make a refund to you later than chase you for the taxes.

 

[dennygt]

How would Michigan know your "exact tax liability" until you file your return?

I suppose they figure it is easier for them to make a refund to you later than chase you for the taxes.

They multiplied the converted amount by .0435 (the tax is a flat rate on everyone). They must assume that I made enough in other income to reach the max. They also know my pension as it's through their public employee retirement system, as I was an instructor. I should get something back, as the rate is supposed to drop to .0425. YAY!

 

[rescueme]

How would Michigan know your "exact tax liability" until you file your return?

I would assume it's a flat tax rate, with no deductions.

As for us? We pay no taxes on any withdrawls (along with SS, pension, SPIA, etc. income).

When we did our respective 401(k) to IRA rollovers, there was no tax involved (federal, state, or local). The state/local taxes were paid at the time of the contribution; however gains after that time are not taxed, regardless of the amount. FIT will be paid upon withdrawl.

We have a standard 15% taken out of our monthly TIRA withdrawls, and in December (when we get our TurboTax software), we adjust that tax amount in order to try to have no more than $50 +/- due in FIT. Last year I skipped the December tax payment. This year, both DW/me will let the December tax payments be paid as normal. We have a bit more income this year due to DW's retirement in March along with a lot of vacation/sick pay income upon her leaving her company.

We don't file quarterly, since we have no outside income and the FIT is paid monthly...

 

[KingB]

When we did our respective 401(k) to IRA rollovers, there was no tax involved (federal, state, or local). The state/local taxes were paid at the time of the contribution;

I understand there are no taxes on rollovers. But, I thought that 401K contributions are not taxed by both federal and state. I wonder if it varies from state to state, but here in IL, 401K contributions are not taxed.

 

[kaneohe]

OT or is it? There will be some periods when we start RMD that we will be on the (presently) 25% tax bracket. Would it be wise to up my Roth conversion before RMD so that some of the amounts will be on the 25%.

The conventional analysis suggests that if you convert to Roth or withdraw from TIRA at the same tax rate, the Roth is ahead if you pay the conversion taxes from outside sources and the Roth/TIRA are equal if you pay conversion taxes from the TIRA.

That suggests that if you convert at 25% or withdraw at 25% , the deciding factor might be where you pay the conversion tax from. Some other factors: if tax rates go up in future, then it might be beneficial to convert to convert more. A complicating factor: if you have significant qualified dividends/LTCG, converting more into the 25% bracket might actually result in a 30% effective rate now (15% on the extra conversion if still in the 15% bracket for ordinary income + 15% on QDIV/LTCG displaced into the 25% bracket).

 

[RE2Boys]

I understand there are no taxes on rollovers. But, I thought that 401K contributions are not taxed by both federal and state. I wonder if it varies from state to state, but here in IL, 401K contributions are not taxed.

It does vary from among the states. Rescueme is in PA. PA does not give you a deduction for 401k or IRA contributions at all. And withdrawals from 401k or IRAs or not taxable if taken after normal retirement age (coded as 7 or 4 on a federal 1099-R). If early withdrawal, PA will tax that part of the withdrawal that exceeds your cost in the retirement plan.

 

[rescueme]

It does vary from among the states. Rescueme is in PA. PA does not give you a deduction for 401k or IRA contributions at all. And withdrawals from 401k or IRAs or not taxable if taken after normal retirement age (coded as 7 or 4 on a federal 1099-R). If early withdrawal, PA will tax that part of the withdrawal that exceeds your cost in the retirement plan.

Exactly.

Additionaly, any gains from the point of contribution (when taxes are paid) are tax free (assuming you are retired) for state/local purposes.

Since our contributions were taxed at the time of contribution (since 1982) we have a lot of gains that are not taxed by our state/local government. Of course, FIT will be paid as we withdraw. Even that (with a mixture of non-deductable IRA's, such as the 11 year period of 1987-97, along with Roth IRA's) keeps our total FIT low.

Also, when DW starts her two (small) pensions in six months, along with SS a year after that, no state/local taxes are due. It's the same for me, concerning SS. I'll be claiming 50% of DW's SS when she files, for 3.5 years until I turn 70 and then claim my own. No state/local taxes due.

Additionally, our joint lifetime SPIA (purchased when we retired, after the age of 59.5) is also free of state/local taxes. It was purchased with part of tax-deferred funds I received from my former company from their cash balance retirement plan after I retired. Of course, I do pay FIT on the annual distribution, but nothing on the state/local side.

PA treats retires well tax-wise, IMHO.