Roth Conversion Noob

[RetiredAt49]

I retired at the beginning of this year at age 49. We have been living off our savings account and business buyout so our taxable income is $0. Our ACA administrator contacted us and they wanted us to switch to Medicaid, which I politely said no.

Thus, I need to perform my first Roth conversion. Can someone explain exactly how it works? Specifically, I have a $300,000 traditional IRA. If I transfer $50,000 this year, is the $50,000 considered income (e.g. as though I had worked for a company and made $50,000 as a 1099 contractor)? I guess I don’t understand how Roth conversions are taxed

 

[SevenUp]

In short, it is ordinary income that is not subject to FICA taxes. See line 4 of Form 1040.

See Roth IRA conversion for more.

 

[VanWinkle]

Yes the conversion will show up as taxable income like a withdrawal from your IRA, without any FICA taxes(SS or Medicare). This will qualify as income to get you over the medicaid hurdle. You only need to get over the 138% of the poverty rate in Illinois(my home state) to get past the medicaid threshold. Find out what the minimum income should be to get the maximum ACA subsidies before doing the conversion.

 

[SecondCor521]

You may want to look at your tax situation over the remainder of your life to see if Roth conversions above what is necessary to retain ACA coverage would be beneficial.

Frequently paying no taxes now results in much higher taxes later due to RMDs and taxable Social Security. Shifting some of that income earlier on a voluntary basis to even out one's top marginal rate can result in lower taxes overall and more after-tax spendable income.

The details vary with the individual's tax situation, but since it sounds like you're young, married, retired early, and have a decent amount in your traditional IRA it might be worth investigating.

 

[pb4uski]

I retired at the beginning of this year at age 49. We have been living off our savings account and business buyout so our taxable income is $0. Our ACA administrator contacted us and they wanted us to switch to Medicaid, which I politely said no.

Thus, I need to perform my first Roth conversion. Can someone explain exactly how it works? Specifically, I have a $300,000 traditional IRA. If I transfer $50,000 this year, is the $50,000 considered income (e.g. as though I had worked for a company and made $50,000 as a 1099 contractor)? I guess I don’t understand how Roth conversions are taxed

A Roth conversions is just a transfer of assets from a tIRA to a Roth IRA. These transfers can be cash or in-kind. So if it was an in-kind transfer and you have 1000 shares of XYZ Company worth $50,000 you can have your tIRA custodian transfer those shares to your Roth IRA and the withdrawal is valued based on the value of the shares transferred.

Assuming that all of your contributions were deductible, then all conversions are considered ordinary income... technically IRA distributions reported on line 4b of Form 1040.

You may want to consider doing more than $50,000 if you expect to be in a higher tax bracket later in life once any pensions or SS are online, especially if you or your spouse have additional tax-deferred money.

 

[RetiredAt49]

You may want to consider doing more than $50,000 if you expect to be in a higher tax bracket later in life once any pensions or SS are online, especially if you or your spouse have additional tax-deferred money.

Yeah it’s a balancing act because we are trying to take advantage of the ACA subsidies (and thus keep our income low) but we don’t want to be so low that we get stuck on Medicaid.

 

[latexman]

I retired at the beginning of this year at age 49. We have been living off our savings account and business buyout so our taxable income is $0. Our ACA administrator contacted us and they wanted us to switch to Medicaid, which I politely said no.

Thus, I need to perform my first Roth conversion. Can someone explain exactly how it works? Specifically, I have a $300,000 traditional IRA. If I transfer $50,000 this year, is the $50,000 considered income (e.g. as though I had worked for a company and made $50,000 as a 1099 contractor)? I guess I don’t understand how Roth conversions are taxed

Won’t you get hit with the 10% early withdrawal penalty (pre 59.5 years old)?

 

[RetiredAt49]

Won’t you get hit with the 10% early withdrawal penalty (pre 59.5 years old)?

It's my understand that a roth conversion (moving money/stock from a traditional IRA to a roth IRA) does not trigger a penalty because I'm not taking the money out of a retirement account and in to my pocket... just moving assets between retirement accounts.

 

[SevenUp]

Won’t you get hit with the 10% early withdrawal penalty (pre 59.5 years old)?

Money Converted From Any Traditional IRA Into a Roth IRA is not subject to that penalty.

 

[Al18]

You can’t pay the taxes due on the Roth conversion from the IRA, if you are less than 59 1/2 without incurring the 10% penalty. I confirmed this with a Fidelity representative recently.

You can do the Roth conversion, but you must pay the taxes from outside the IRA and submit them with the appropriate IRS form. I don’t know the form #.

 

[SecondCor521]

You can’t pay the taxes due on the Roth conversion from the IRA, if you are less than 59 1/2 without incurring the 10% penalty. I confirmed this with a Fidelity representative recently.

To be more specific, the 10% penalty would only be on the amount of the Roth conversion withheld for taxes, not on the entire amount.

You can do the Roth conversion, but you must pay the taxes from outside the IRA and submit them with the appropriate IRS form. I don’t know the form #.

Roth conversions are reported on part II of Form 8606. Any withholding would be reported on the 1099-R from the IRA custodian. Any estimated taxes would typically be paid along with a Form 1040-ES.

 

[38Chevy454]

To be more specific, the 10% penalty would only be on the amount of the Roth conversion withheld for taxes, not on the entire amount.







Roth conversions are reported on part II of Form 8606. Any withholding would be reported on the 1099-R from the IRA custodian. Any estimated taxes would typically be paid along with a Form 1040-ES.

To make even easier, you can pay the estimated taxes electronically. On the IRS website. Just put in the correct tax year and your bank info, along with the date to pay.

 

[pb4uski]

Won’t you get hit with the 10% early withdrawal penalty (pre 59.5 years old)?

Not on Roth conversions because they are not a withdrawal... a transfer from a traditional IRA to a tax-free Roth IRA.

 

[pb4uski]

To be more specific, the 10% penalty would only be on the amount of the Roth conversion withheld for taxes, not on the entire amount. ...

Yes, that is a trap that some people under 59-1/2 fall into... having the taxes withheld sounds attractive but don't so it because the taxes withheld are considered to be a withdrawal and therefore subject to the 10% penalty.

Move 100% from tIRA to Roth and then pay taxes from other money. Of course, make sure you have the other money for the taxes before doing the conversion.

 

[sengsational]

What I do is enter my situation into tax software and keep knotching up the conversion amount and watch what happens. There are bumps and wiggles. It used to be real obvious when your conversion was too big because it hit the cliff and the marginal rate went off the chart. But now that the cliff has been replaced by a ramp, it's just a matter of comfort level that you're not paying a higher rate than you'll likely be paying at RMD time.

I usually do my conversion in December, once most of the year's finances are known, and the tax software is available.

 

[CRLLS]

So if someone in the 12% tax bracket was paying a 10% penalty wouldn't it effectively change the tax rate to 13.2% correct? If so, it doesn't seem like a big hit to me.

 

[Alan]

So if someone in the 12% tax bracket was paying a 10% penalty wouldn't it effectively change the tax rate to 13.2% correct? If so, it doesn't seem like a big hit to me.

It’s irrelevant as there is no penalty for doing an IRA to Roth conversion. I did several before age 59.5.

 

[CRLLS]

It’s irrelevant as there is no penalty for doing an IRA to Roth conversion. I did several before age 59.5.

If the taxes for the conversion are paid from non-IRA sources, you are correct. But some of us do not have the cash to pay the taxes from other resources or choose to do so for other reasons. When you must pay those taxes from the IRA, then the tax at your current tax bracket rate and the 10% penalty come from the IRA.

 

[Alan]

If the taxes for the conversion are paid from non-IRA sources, you are correct. But some of us do not have the cash to pay the taxes from other resources or choose to do so for other reasons. When you must pay those taxes from the IRA, then the tax at your current tax bracket rate and the 10% penalty come from the IRA.

Gotcha, good point. That certainly changes the calculation a little.

 

[pb4uski]

So if someone in the 12% tax bracket was paying a 10% penalty wouldn't it effectively change the tax rate to 13.2% correct? If so, it doesn't seem like a big hit to me.

No, the penalty is 10% of the withdrawal, not 10% of the tax, so in your example 22%, not 13.2%.

 

[CRLLS]

So let's get this straight, if I am in the 12% tax bracket, under 59-1/2 and do a Roth conversion of 100K from the IRA and pay all taxes & penalties from that IRA. I start by taking 100K out of the IRA. Some of that is going to taxes. How much more than simple taxes is the penalty?

1st pass = 12% of the 100K is taxable, or 12K leaving 88K to go to the Roth. But wait, 10% of that 12K is a penalty 2nd pass = 10% of 12% is 1.2%. An additional 1.2% on top of 12% is 13.2%. This puts 86.8K to the Roth. That would be a nontaxed part of the IRA withdrawal.

I admit that I haven't gone through the tax forms. Are you saying that the entire 100K gets penalized? i.e. 22% of the IRA withdrawal goes to Uncle Sam? That doesn't sound right or fair.

 

[NW-Bound]

If you don't have money out-of-pocket to pay taxes, you need to withdraw beyond the conversion amount, and this results in more taxes, and also a penalty (penalty only for people below 59-1/2). Then, you need to withdraw more, and this leads to more taxes, and penalty. So how to compute this?

As an example, I worked out the OP's info. See if I am correct.

Suppose you want to have $50K in income by Roth conversion, and have no other sources of income.

For a married couple filing jointly, you are allowed a standard deduction of $25,100. This means your taxable income is $24,900. The Fed tax on this $24,900 is $2,590.

You will also have to pay a state income tax. Let's say that your state tax is $645, for a combined tax of $2590+$500 = $3235.

Case 1) $50,000 withdrawal, $50,000 conversion, $2,590 Fed tax, $645 state tax, $0 penalty -> Need $3,235 out of pocket

If you don't have this $3235 cash you will have to bump up the $50,000 to have extra for taxes. But then, the additional $3,235 is now income to be taxed, plus the 10% penalty.

Case 2) $53,235 withdrawal, $50,000 conversion, $2,978 Fed tax, $729 state tax, $324 penalty -> Need $796 out of pocket ($2,978 + $729 + $324 - $3,235) .

Let's bump the additional $3,235 to $3,235 + $796 = $4,031.

Case 3) $54,031 withdrawal, $50,000 conversion, $3,074 Fed tax, $749 state tax, $403 penalty -> Need $195 out of pocket ($3,074 + $749 + $403 - $4,031).


As you can see, increasing the withdrawal to pay for tax leads to more taxes and penalty. However, the amount ouf-of-pocket keeps getting smaller and smaller. If you keep the iteration, eventually it will converge.


A quicker way to compute this is to recognize that it is a geometric series. Each $1 you withdraw above the $50,000 for conversion costs you 12% for Fed tax, 2.6% for state tax (I use AZ tax here), and 10% for penalty. For each $1 that you withdraw, you only have 75.4c left. In order to obtain the original $1, you will need to withdraw 1/0.754 = 1.326. For the original amount of $3,235 that you do not have out-of-pocket, you will need to withdraw $4,290.

Let's check it out.

Case Final) $54,290 withdrawal, $50,000 goes to Roth, $3,105 Fed tax, $756 state tax, $429 penalty. No money out of pocket.

Conclusion: It takes $54,290 of withdrawal to convert $50,000, because your total tax+penalty is $4,290. Your ACA income is $54,290.

The net effective rate of the conversion is 7.9%. That's excellent because you make use of your standard deduction when your income is low. Wait till you draw SS or pension or IRA. Your tax rate will be much higher.

 

[SevenUp]

I admit that I haven't gone through the tax forms. Are you saying that the entire 100K gets penalized? i.e. 22% of the IRA withdrawal goes to Uncle Sam? That doesn't sound right or fair.

One could debate "fair" but that is right. See Part I of Form 5329.

 

[pb4uski]

So let's get this straight, if I am in the 12% tax bracket, under 59-1/2 and do a Roth conversion of 100K from the IRA and pay all taxes & penalties from that IRA. I start by taking 100K out of the IRA. Some of that is going to taxes. How much more than simple taxes is the penalty?

1st pass = 12% of the 100K is taxable, or 12K leaving 88K to go to the Roth. But wait, 10% of that 12K is a penalty 2nd pass = 10% of 12% is 1.2%. An additional 1.2% on top of 12% is 13.2%. This puts 86.8K to the Roth. That would be a nontaxed part of the IRA withdrawal.

I admit that I haven't gone through the tax forms. Are you saying that the entire 100K gets penalized? i.e. 22% of the IRA withdrawal goes to Uncle Sam? That doesn't sound right or fair.

It's right.... that's why they call it a penalty, silly. They want to make it unattractive for people to withdraw money before they are 59-1/2. I think it is good... that way people are less inclined to take money out of their retirement plans for a new toy of some sort or splurge vacations or whatever which preserves that money for their retirement.

 

[explanade]

A Roth conversions is just a transfer of assets from a tIRA to a Roth IRA. These transfers can be cash or in-kind. So if it was an in-kind transfer and you have 1000 shares of XYZ Company worth $50,000 you can have your tIRA custodian transfer those shares to your Roth IRA and the withdrawal is valued based on the value of the shares transferred.

What about 401k assets that you left in your old 401k account?

Or would you have to transfer those to tIRA and then transfer again to Roth?

But these conversions only make sense if you have low taxable income right?

If you have relatively high income, then the 401k distributions just raise the taxable income. I understand the general strategy though, when you're forced to take RMDs at age 70, it's better to have as much retirement assets in Roth IRA, not tIRA or 401k.