The ability to take tax-free withdrawals during retirement encourages many people to contribute to a Roth IRA. A taxpayer with a traditional IRA can get in on the tax savings by converting his account to a Roth IRA. Since most taxpayers fund a traditional IRA with after-tax money, the IRS will impose taxes and possibly penalties on the converted account.
Converting a traditional IRA to a Roth IRA may add to your taxable income for the year. Pre-tax or deductible IRA contributions and the earnings on a traditional IRA that are converted will be taxed at your normal income tax rate for the year. Your marginal tax rate could also increase substantially because of the increase in taxable income for the year, pushing you into a higher bracket. This applies to both federal and state taxes.
Paying the Taxes from the IRA Balance
You should pay the taxes due on the converted IRA account with money that you hold outside of the IRA. If you have to withdraw money from the traditional IRA to pay the taxes and are under age 59 1/2, it will end up costing you more. The IRS imposes a 10 percent tax penalty on pre-tax money or earnings from a traditional IRA for anyone under age 59 1/2 for most withdrawals.
Tax Brackets in Retirement
If you expect your income to drop in retirement, you will probably be in a lower tax bracket during your non-working years. By holding the money in a traditional IRA, you can wait and pay the taxes on the money when you withdraw it during retirement, rather than paying the taxes when your marginal rate is higher during your peak income years. If you are younger, you have more time to earn tax-free money, which will probably make up for the immediate tax bite of making the conversion.
Converting a traditional IRA account to a Roth account could result in other costs related to taxes. By converting the IRA and increasing your income, you may no longer qualify for certain government benefits. In addition, you may not be eligible for some tax credits, such as the child tax credit, because many tax credits require your income to be below a certain level. You may not qualify for some itemized deductions because they have a minimum deductible amount based on a percentage of gross income. Examples are medical expense deductions and deductions for miscellaneous employee business expenses.
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