If you want to make a switch from saving pretax dollars in a traditional individual retirement account, or IRA, to saving after-tax dollars, you can convert to a Roth IRA. However, Roth IRA conversions are subject to income taxes.
Roth IRA Conversion Taxes
In general, the entire amount of your tax-deferred retirement plan conversion to a Roth IRA will add to your taxable income for the year. For example, if you convert $35,000 from your 403(b) plan to your Roth IRA, you have to report an additional $35,000 of taxable income on your tax return for the year. You can use either Form 1040 or Form 1040A to file your taxes for the year of the rollover.
Nondeductible Contribution Exception
In rare circumstances, you may have made contributions to your traditional IRA for which you choose not to claim an income tax deduction. In this case, the amount of your Roth IRA conversion that represents these nondeductible contributions can be converted tax-free. For example, if you convert a traditional IRA that has 42 percent nondeductible contributions, 42 percent of your conversion is tax-free. If you convert $30,000, $12,600 does not add to your taxable income -- only $17,400 is the taxable amount.
Tax Rates on Conversions
The taxable amount of your Roth IRA conversion is taxed at your marginal income tax rate, which gives you an incentive to time your conversion to a year that you fall in a lower income tax bracket. You may fall in a lower bracket if you are paid on commission and have a poor sales year, are unemployed for a large portion of the year or have many of adjustments and deductions. For example, if you fall in the 20 percent tax bracket, your conversion will be taxed at 20 percent.
Paying the Taxes
The Internal Revenue Service does not prohibit you from taking money from your tax-deferred retirement account to pay the taxes on the conversion. However, unless you are 59 1/2 years old, the IRS will charge not only income taxes on the amount not converted, but also a 10 percent early withdrawal penalty. For example, if you are 50 when you perform the conversion and you withdraw $3,000 to pay for taxes on the conversion, that $3,000 counts as taxable income and you owe a $300 tax penalty. Therefore, you should try to foot your income tax bill from funds outside of your tax-deferred retirement account.
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