I want to convert $250,000 from my traditional IRA to a Roth. As I understand it, I have to pay income tax on the $250,000. Can the tax be paid from funds in an IRA? Or do I have to pay taxes outside of the IRA?
– Kevin
This one is very simple. The IRS doesn't care where the money comes from. As long as you write them a check, they'll be happy!
Just kidding – yes, $250,000 is included in your gross income. You can use converted funds or funds from other sources to pay the tax, but the difference can be significant. If you have the option, you may want to consider using non-IRA funds to pay your taxes.
A financial advisor can help you make important retirement planning decisions, such as when to make a Roth conversion and how much. Contact a financial advisor.
To understand the tax implications of a Roth conversion, it helps to think about the role of this type of transfer. A Roth conversion allows you to transfer funds from a traditional tax-deferred retirement account to a Roth IRA.
The main idea behind tax-deferred retirement accounts is right in the name. When you contribute money to a traditional IRA, 401(k), or similar account, you can deduct the amount from your current gross income, thereby avoiding a tax liability for the current year. Instead, tax liability is deferred until you withdraw funds from the account. This deferral also applies to growth, dividends and interest earned on the funds.
Typically, this tax bill is due when you start taking withdrawals in retirement. However, rolling that money into a Roth IRA also removes it from the account, triggering income taxes. Assuming you made a deductible contribution to an IRA (as opposed to a nondeductible contribution), the converted funds will be added to your gross income for the year and increase your tax liability. (A financial advisor with tax planning expertise can be a valuable resource when you are making important financial decisions, especially regarding retirement.)
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You can use a portion of the converted balance or funds outside of an IRA to pay the tax bill on a Roth conversion. Here's a closer look at both options:
In fact, many people rely on the converted funds to pay their converted income taxes. If you don't have funds outside of an IRA to pay taxes, this may be your only option. If this is the case, you can usually have the financial institution hold the money while the exchange is made.
If you have enough saved outside of an IRA to cover the taxes, that's almost always the better option from a retirement savings perspective. By taking this approach, you not only avoid potential tax penalties for using converted funds to pay taxes, but you also ensure that the entire converted balance in your Roth account grows tax-free. Of course, be careful not to deplete your emergency savings.
For example, let's say someone in the 24% marginal tax bracket is converting $100,000, and they have $24,000 in cash that they can use to pay their tax bill:
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If they used the converted funds to pay taxes, they would be left with just $76,000 after taxes in their Roth IRA and $24,000 in taxable savings or brokerage accounts.
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If they use the cash saved to pay taxes, the entire $100,000 will be deposited into a Roth IRA.
The biggest difference is how the two accounts are taxed. Since a Roth IRA is tax-free, it's much more efficient to maximize your savings, especially if you plan to invest the money over a period of time. (If you need help navigating a retirement planning scenario like this, consider being matched with a financial advisor.)
If you are not yet 59 ½ years old, be sure to consider the 10% early withdrawal penalty. The conversion itself is not subject to this penalty, but any amount you use to pay taxes is. If you're under 59 ½, it's more valuable to use cash savings to pay the conversion tax.
Additionally, the penalty applies regardless of whether you withheld part of the tax when you converted or you took money out of the Roth IRA when you filed your tax return. Withdrawing these funds less than five years after the conversion violates the five-year rule for Roth conversions and triggers a 10% early withdrawal penalty if you are under age 59 ½. (This five-year rule can be confusing, but a financial advisor can help you navigate it and potentially avoid costly tax penalties.)
You can pay the tax bill on a Roth conversion from any source. You can withhold a portion of the conversion fee; you can wait until tax time and withdraw it from your Roth balance; or you can use outside savings to pay your tax liability. Keep in mind that if you use IRA funds to pay taxes, you may be subject to early withdrawal penalties. If you can, paying in external dollars is usually a better option.
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Hiring a financial advisor isn't just about finding the one who will get the greatest return on your investment. Of course, this is important, but you should also look to work with an advisor whose services and areas of expertise align with your needs. For example, if you need help sorting out your estate and developing a plan for how to pass on your wealth in a tax-efficient manner, you will want to find an advisor who provides estate and estate planning services. After all, not all consultants specialize in these areas.
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Finding a financial advisor isn’t difficult. SmartAsset's free tool matches you with up to three vetted financial advisors serving your area, and you can have a free introductory call with your advisor to decide which one you think is the best fit for you. If you're ready to find an advisor who can help you achieve your financial goals, get started today.
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Keep an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid—held in an account that is not at risk of large swings like the stock market. The trade-off is that the value of liquid cash may be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts at these banks.
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Brandon Renfro, CFP®, is a SmartAsset financial planning columnist who answers reader questions on personal finance and tax topics. Have a question you'd like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column. Some reader-submitted questions have been edited for clarity or brevity.
Please note that Brandon i is not a participant in the SmartAsset AMP platform, nor an employee of SmartAsset, and has received compensation for this article.
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