Rollover IRA Conversion to Roth in 2013

[mikeinannarbor]

Hello,

I am interested in transferring about $12K that I currently have in a Fidelity Rollover IRA from my retirement account with my previous employer. I'd like to convert the account to a Roth IRA, but want to make sure I do it right. I'm a little fuzzy on whether to have federal taxes withheld or to not.

From what I can tell - I should NOT have taxes withheld because I may face 10% early withdrawal penalty (I'm 29 yrs old). Right? What might I be missing here?

Thanks for the help!
Mike

[Petunia 100]

Hello,

I am interested in transferring about $12K that I currently have in a Fidelity Rollover IRA from my retirement account with my previous employer. I'd like to convert the account to a Roth IRA, but want to make sure I do it right. I'm a little fuzzy on whether to have federal taxes withheld or to not.

From what I can tell - I should NOT have taxes withheld because I may face 10% early withdrawal penalty (I'm 29 yrs old). Right? What might I be missing here?

Thanks for the help!
Mike

Hi Mike,

There is no penalty for converting, and there won't be anything withheld so long as you do not cash it out and take possession of the money. What will happen is that when you file your 2013 income tax return, you will claim the amount converted as income.

You might want to adjust your withholding on your paycheck this year, so that more income tax is withheld.

Are you sticking with Fidelity? I'd just give them a call and tell them what you want. If you're not sticking with Fidelity, then contact your new custodian instead. You want a direct transfer to your custodian to avoid withholding.

[mikeinannarbor]

Hi Mike,

There is no penalty for converting, and there won't be anything withheld so long as you do not cash it out and take possession of the money. What will happen is that when you file your 2013 income tax return, you will claim the amount converted as income.

You might want to adjust your withholding on your paycheck this year, so that more income tax is withheld.

Are you sticking with Fidelity? I'd just give them a call and tell them what you want. If you're not sticking with Fidelity, then contact your new custodian instead. You want a direct transfer to your custodian to avoid withholding.

Thank you for the info. I don't have a reason to move from Fidelity. Makes sense re: what happens on my 2013 income tax return. Thanks again...

[disneysteve]

I've always heard that when converting, you should pay the taxes from outside funds, not from the principal of the IRA. That way, you don't lose ground in the account. If you can't afford to do that, I'd really run the numbers to see if the conversion makes sense to do.

[bUU]

Are you even allowed to pay from the deductible assets in the IRA, without paying a penalty?

[Petunia 100]

Are you even allowed to pay from the deductible assets in the IRA, without paying a penalty?

Nope.

[jpg7n16]

Hello,

I am interested in transferring about $12K that I currently have in a Fidelity Rollover IRA from my retirement account with my previous employer. I'd like to convert the account to a Roth IRA, but want to make sure I do it right. I'm a little fuzzy on whether to have federal taxes withheld or to not.

Are you okay having $12k added to your income this year? Can you pay the taxes out of pocket from other sources?

If yes to both, sounds good. I would not have the taxes withheld. More to continue...

From what I can tell - I should NOT have taxes withheld because I may face 10% early withdrawal penalty (I'm 29 yrs old). Right? What might I be missing here?

Thanks for the help!
Mike

Are you even allowed to pay from the deductible assets in the IRA, without paying a penalty?

The answer to both qustions is that any funds withheld during conversion are considered a withdraw of their own. Unless some exception to the penalty applies, then you'd be subject to the penalty on whatever you withheld. (ie. age 59 1/2, disability, etc. -- see full list here: Tax Topics - Topic 558 Additional Tax on Early Distributions from Retirement Plans, Other Than IRAs )


So say you convert $12k and w/hld 20%

2400 to the IRS (subject to tax + potential penalty tax)
9600 to the Roth (subject to tax only -- exempt from penalty due to direct rollover exemption)

It's like you're taking a $2400 early withdraw to pay taxes. And voluntarily paying your taxes by taking an IRA withdrawal is not one of the exceptions.

Maybe one of the other exceptions applies to OP and if so, he'd be able to do it penalty free, but I doubt it. That's usually not the case.


Note:
If there's any possibility that you may need to recharacterize (aka undo) the conversion by the end of the year, then I would 1st roll to a Rollover IRA, and then convert from there. You can recharacterize back into the Rollover IRA if needed, but you can't recharacterize back into a 401k/403b plan once you've left.

[disneysteve]

Are you even allowed to pay from the deductible assets in the IRA, without paying a penalty?

Nope.

Are you sure about that Petunia? Everything I've ever seen says you can pay the taxes from the IRA funds without penalty. It just isn't a good idea to do so.

From Vanguard:
You have to pay income taxes on the money you convert from a tax deductible IRA. The conversion also can bump you into a higher tax bracket.

You can get the most benefit if you use money outside of your IRA to pay the conversion taxes. Drawing from a cash account can be a good way to cover the taxes.

From Wells Fargo:
Before converting there are a few things to consider:

The availability of funds to pay income taxes. The benefits of a conversion are increased if the income taxes due can be paid out of non-IRA assets.

From your-roth-ira.com:
Let's say you funded your entire Traditional IRA with tax deductible dollars.

Your Traditional IRA has a balance of $150,000. You decide to convert the Traditional IRA to a Roth IRA because you don't want to pay taxes upon withdrawal in retirement...

So, how is the conversion treated?

It's treated just like regular taxable income in the same tax year in which you make the conversion.

So if you make your Roth conversion in 2010, the $150,000 in your Traditional IRA is added to your 2010 income and taxed accordingly.

Let's say you have an income tax rate of 40%. In this case, you owe $60,000 in income taxes as a result of converting your Traditional IRA to a Roth IRA.

You now have a Roth IRA with $90,000. You owe zero additional taxes, and your conversion is NOT subject to a 10% early withdrawal penalty.

[jpg7n16]

Hey DS, I notice that both firms you quote are talking about other benefits to paying out of pocket, and do not specifically address the implications of withholding on the conversion.

The other site "your roth ira.com" just seems to be run by some guy. I don't know if that's a reputable site or not.

I was able to find a specific reference in a Kiplinger article here:

FAQs on the New Roth Conversion Rules-Kiplinger

You'll be asked if you want taxes withheld from the amount you move to the Roth. (Remember, moving money from a traditional IRA to a Roth triggers a tax bill on the full amount, unless you’ve made nondeductible contributions to the traditional account, in which case part of the conversion is tax-free.) It’s best to say "no to withholding and pay the bill with non-IRA funds. If you dip into the IRA to satisfy the IRS, you'll owe tax on that amount, too, in addition to the funds you're moving to the Roth. And, if you're younger than 59 1/2, you'll also be slapped with a 10% penalty on the money used to pay the tax bill.

Read more at FAQs on the New Roth Conversion Rules-Kiplinger

It's always been my understanding that the funds actually moved to the Roth are direct rollover exempt, and anything withheld does not fall under that exemption (as it doesn't go into the new account) and must be dealt with separately.

As your 1099 will show say $12k coming out of the plan/IRA, but your 5498 will only show $9600 being put back into a Roth account, the remainder (in this case "withholdings") will be considered an early withdrawal.

[Petunia 100]

Are you sure about that Petunia? Everything I've ever seen says you can pay the taxes from the IRA funds without penalty. It just isn't a good idea to do so.

From Vanguard:
You have to pay income taxes on the money you convert from a tax deductible IRA. The conversion also can bump you into a higher tax bracket.

You can get the most benefit if you use money outside of your IRA to pay the conversion taxes. Drawing from a cash account can be a good way to cover the taxes.

From Wells Fargo:
Before converting there are a few things to consider:

The availability of funds to pay income taxes. The benefits of a conversion are increased if the income taxes due can be paid out of non-IRA assets.

From your-roth-ira.com:
Let's say you funded your entire Traditional IRA with tax deductible dollars.

Your Traditional IRA has a balance of $150,000. You decide to convert the Traditional IRA to a Roth IRA because you don't want to pay taxes upon withdrawal in retirement...

So, how is the conversion treated?

It's treated just like regular taxable income in the same tax year in which you make the conversion.

So if you make your Roth conversion in 2010, the $150,000 in your Traditional IRA is added to your 2010 income and taxed accordingly.

Let's say you have an income tax rate of 40%. In this case, you owe $60,000 in income taxes as a result of converting your Traditional IRA to a Roth IRA.

You now have a Roth IRA with $90,000. You owe zero additional taxes, and your conversion is NOT subject to a 10% early withdrawal penalty.

DisneySteve,

If 20% is withheld, it is considered a distribution. Since Mike is only 29, it's a premature distribution subject to penalty. That's why he doesn't want anything withheld.

ETA: I also believe the example from your-roth-ira is incorrect. Conversions must be 5 years old before they can be withdrawn without penalty.

[disneysteve]

I did some more research and it looks like I was wrong about the tax issue. If you pay the tax with funds from the IRA, you do pay the 10% penalty if you are under 59-1/2. This should be avoided for multiple reasons. So what I said first still stands. If you can't pay the taxes from outside funds, you probably shouldn't be converting to the Roth.

[mikeinannarbor]

Thanks all for the help. I didn't withhold - so it looks like I'll pay income tax on the amount come tax time.