#Tax #Pay #Roth #IRA #Conversion
If you’re thinking about doing a Roth IRA conversion, you’re probably wondering how much tax you’ll end up paying. You will owe income tax on the full amount you convert from a traditional IRA to a Roth IRA in the year you make the switch.
The tax amount will depend on your income tax bracket and your income tax rate, which ranges from 10% to 37% for 2025. The money you transfer is added to your gross income for the tax year. Determining when a Roth IRA conversion makes financial sense for you involves evaluating the current and future tax consequences before taking action.
Key takeaways
- You can roll over money to a Roth IRA from a traditional IRA or 401(k) by doing a Roth IRA conversion.
- The amount you convert is added to your gross income for the tax year in which you make the switch.
- Tax rates in 2025 range from 10% to 37%, and the conversion amount could push you into a higher tax bracket.
- If you think you’ll be in a higher tax bracket when you retire, the long-term benefits could outweigh any tax you pay for the conversion now.
Taxes on a Roth IRA conversion
When you convert to a Roth IRA from a traditional IRA, the amount you convert is added to your gross income for that tax year. It increases your income, and you pay the regular tax rate on the transfer.
Let’s say you’re in the 22% tax bracket and you transfer $20,000. Your income for the tax year will increase by $20,000. Assuming this doesn’t push you into a higher tax bracket, you’ll owe $4,400 in taxes on the conversion.
If the conversion pushes you into a higher tax bracket, the amount above the bracket threshold will be taxed at the higher rate, 24%, in 2025.
It’s never a good idea to use your retirement account to cover the tax you owe on the transfer. Doing so will reduce your retirement balance, which could cost you thousands of dollars in long-term growth. Instead, set aside enough cash in a savings account to cover your transfer taxes.
Why convert a Roth IRA?
The biggest difference between Roth IRAs and tax-deferred retirement accounts like traditional IRAs and 401(k)s is the point at which you pay the tax. IRA and traditional 401(k) contributions are tax deductible for the year you make them, and you pay income tax on withdrawals in retirement. The money you pay and the money you earn are taxable.
Roth IRA contributions do not provide an upfront tax break, but withdrawals in retirement are tax-free. For a Roth IRA earnings withdrawal to be eligible, the account must be at least five years old and you must be at least 59 ½ years old.
There are several reasons to consider a Roth IRA conversion (also called a rollover). If you want to contribute to a Roth directly but make too much money to qualify, you can legally exceed the income limits by doing a Roth IRA conversion. This strategy is often called a “Roth” backdoor.
Another good reason to make the switch is if you expect to be in a higher tax bracket in retirement than you are now. Remember, Roth IRA withdrawals are tax-free in retirement — even when you take dividends. You can pay taxes now while you’re in a lower tax bracket and enjoy tax-free withdrawals later.
How to do a Roth IRA conversion
If you decide that a Roth IRA conversion makes sense for you, here’s what you need to do to make it happen:
- Place the money in a traditional IRA (or other retirement account): You will have to open and fund a new account if you do not already have one.
- Pay taxes on your IRA contributions and earnings: If you deducted your traditional IRA contributions (which you did if you met the income limits), you should return that tax deduction now.
- Convert the account to a Roth IRA: If you don’t have a Roth IRA yet, you’ll open one during the conversion.
There are several ways to perform the conversion:
- Indirect scrolling: You take a distribution from your traditional IRA and put it into your Roth IRA within 60 days.
- Transfer of trustee to trustee: Have your traditional IRA provider transfer the funds directly to your Roth IRA provider.
- Transferring the same guardian: If the same provider holds both of your IRAs, you can ask that provider to make the transfer.
Convert to a Roth IRA from a 401(k)
If you want to roll over money from your 401(k) to a Roth IRA, make sure you transfer the money directly to your Roth IRA provider. If not, your company will withhold 20% of the amount for tax purposes.
If your company issues a check to you (instead of transferring it to your Roth IRA provider), you have only 60 days to deposit all the money into a new Roth account. The 20% your company withholds for taxes will go to the Roth if done within 60 days. If you don’t meet this deadline — and if you’re under age 59½ — you’ll owe a 10% early withdrawal penalty on any money that doesn’t make it into the Roth.
Either way, you are still on the hook for income taxes on the entire amount you transfer.
Don’t wait all year to pay taxes
Most people pay their income tax to the government with every paycheck. It is set aside automatically, based on the deductions you claim on Form W-4. As the year goes on, your taxes are withheld for you. You don’t have to write a separate check to the government until you file your taxes. And that’s only if you haven’t set aside enough money during the year and still owe more.
Small business owners, self-employed people, and corporations make estimated tax payments quarterly. These entities must estimate how much tax they owe based on their income and expenses. Then, each quarter — usually April 15, June and September of that year and January of the following year — they fill out a form and submit their estimated payments.
Why is it important to note this? If you convert a large traditional IRA to a Roth IRA early in the year, your quarterly income — and therefore your quarterly taxes — will increase. Let’s say you convert during the first quarter of the year. You will need to pay the tax resulting from the conversion when your quarterly reports are due. In this example, that would be mid-April (tax day). If you wait until the end of the year or when you file your taxes, you could end up paying penalties and interest as well.
Safe harbor rules
If you’re used to paying estimated taxes, you may be wondering about the safe harbor rules. The safe harbor rules mean that if you paid at least 100% (or 110%, depending on the situation) of the previous year’s taxes in estimated taxes this year, you won’t pay any fees or interest by underpaying.
This is intended to protect individuals and businesses whose income may rise significantly after a year in which they earned less. Provided you have paid at least the same amount as you did last year, you will be pulled into the Safe Haven. You don’t have to worry about penalties and interest.
However, this is where things can get sticky. For many taxpayers in this situation, it is a good idea to speak with a tax advisor. Of course, if you pay estimated taxes, there’s nothing to worry about. If you end up paying too much in taxes, you’ll get your money back after you file your return for the entire year and pay any balance due.
Should I convert a Roth IRA?
The Roth IRA offers huge benefits — tax-free withdrawals during retirement and no required minimum distributions (RMDs), to name a few. However, converting is not always a good idea. In general, you should only consider switching if:
- You can pay taxes without tapping into IRA funds
- You are confident that you will be in a higher tax bracket in retirement
Keep in mind that you may be in a higher tax bracket later in life even if you don’t earn more money at work. Your income may be higher due to any combination of:
Be sure to consider other sources of income when estimating your future tax bracket.
When should you consider a Roth IRA conversion?
A Roth IRA conversion may be wise if you think you’ll be in a higher tax bracket in retirement than you are now. Since you have to pay taxes on traditional IRAs when you convert them to a Roth account, consider your current tax rate and the value of the account you have now.
How do you know if you’ll be in a higher tax bracket later?
There’s no real way to know what your tax code will look like in retirement — and unfortunately, it changes a lot. What you can try to determine is how many sources of funding you will have in your retirement years. If you have a pension, annuity, rental property, or other sources of passive income, you may earn as much or more in retirement than you do now while working.
What is the penalty for not paying taxes?
If you don’t have taxes withheld from your paycheck, you are expected to pay either 100% of the amount of last year’s tax bill or 90% of this year’s bill. The penalty for underpayment is usually 0.5% of the unpaid tax for each month or partial month that is not paid. In addition to the penalty, underpayments are subject to interest.
Can you avoid paying taxes on a Roth IRA?
No, not when making initial contributions to a Roth IRA. One of the best ways to minimize your Roth IRA taxes after you pay it each year on the amounts you contribute is to avoid making early withdrawals of your investment earnings. Although you can withdraw your contributions at any time, withdrawing earnings before age 59½, or certain other circumstances, will result in income taxes.
Bottom line
If you’re interested in doing a Roth IRA conversion, be sure to consider the current and future tax consequences before making any decisions. If you can cover the taxes and think you’ll be in a higher tax bracket later, it may make financial sense. If not, you may be better off leaving your money in a traditional IRA. It may be helpful to consult a tax or financial advisor who can help you determine if and when a conversion might benefit you.
The retirement security rule: what it is and what it means for investors
The U.S. Department of Labor (DOL), through its Retirement Security Rule, also known as the Fiduciary Rule, intends to protect investors from conflicts of interest when receiving investment advice that an investor uses for retirement savings.
The rule was issued by the Department of Labor on April 23, 2024. It went into effect on September 23, 2024. Additionally, the effective date of some provisions will be postponed to 2025.
The rule will affect people who save and invest for retirement and who use an advisor who serves as a fiduciary under the Employee Retirement Income Security Act (ERISA). These advisors are held to a higher standard – the standard of best credit advice rather than just the minimum appropriate advice standard. Their appointment could restrict the products and services they are allowed to sell to customers saving for retirement.
#Tax #Pay #Roth #IRA #Conversion
