Roth IRA Conversion Using Qualified Money to Pay the Tax

by Mark Kennan

When you convert a traditional IRA to a Roth IRA, the amount of the conversion is added to your taxable income for the year. Depending on your financial situation, you may find yourself struggling to figure out how to pay this extra tax. You may consider using qualified withdrawals from the retirement account to cover the tax.

Qualified Distributions Defined

In order to take out qualified money from a tax-deferred retirement plan, you must be at least 59 1/2 years old. For example, if you are 60 years old when you convert money from a traditional IRA or 401k plan, you can take a qualified distribution from the traditional IRA or 401k plan to pay for the taxes on the remainder of the conversion. If you take out non-qualified money from the retirement plan you are converting into a Roth IRA, you must pay the 10 percent early withdrawal penalty on the withdrawal.

Advantages of Using Qualified Money

A Roth IRA conversion can be quite costly, especially if you have saved up money in your tax-deferred retirement plan for the majority of your career. For example, if you fall in the 33 percent income tax bracket and you convert $40,000, you would have to come up with an additional $13,200 for the income taxes on the conversion. If you wait to convert, you could end up owing even more because any additional earnings that accrue on the tax-deferred retirement plan would also be taxable when you convert.

Disadvantages of Using Qualified Money

When you make a conversion with qualified money to pay the tax, you reduce the amount of money that added to your Roth IRA. For example, if you have $32,500 in your traditional 401k plan and fall in the 30 percent tax bracket, you would have to come up with $9,750 to pay the taxes on the conversion. However, if you do not have the money to pay the tax out-of-pocket, you could convert $25,000 of the distribution and use a qualified distribution of the remaining $7,500 to pay the income taxes.

Alternatives to Using Qualified Money

If you want to avoid tapping your retirement savings to pay the conversion tax, consider making smaller conversions over several years as your budget allows instead of trying to convert it all in one year. In addition to spreading the payments out over time in smaller amounts, you also lower the chances that your conversion income will push you into a higher income tax bracket. However, you may want to convert all the money in one year if you fall in a very low tax bracket, such as if you had to take a significant pay cut or only worked part of the year.

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