If you expect that your current tax bracket is lower than the tax bracket you expect to fall in at retirement, you may be considering converting your traditional IRA to a Roth IRA. With such a conversion comes tax consequences, and understanding the taxes before you make the conversion helps inform your decision.
Reason for Taxes
A traditional IRA allows you to deduct contributions while taxing distributions. With a Roth IRA, the contributions are taxed, but the distributions aren't. If you could freely convert a traditional IRA to a Roth IRA, you could simply put money in your traditional IRA and claim a deduction, then convert it to a Roth IRA and take your distributions tax-free, avoiding all taxes. To prevent this, the IRS requires that you include the amount of your traditional IRA contribution as taxable income when you file your income taxes.
Before converting from a traditional to a Roth IRA, estimate the income taxes you will owe on the conversion. Do this by multiplying your anticipated marginal income tax bracket by the amount of the conversion. For example, if you convert $25,000 and in the 24 percent tax bracket, multiply $25,000 by 0.24 to find your conversion results in $6,000 in extra taxes. If you are near the top of your income tax bracket, or convert a large amount from a traditional IRA to a Roth IRA, it could push you up into the next income tax bracket, resulting in a higher tax rate on the conversion.
When you make a conversion from a traditional IRA to a Roth IRA, you may be tempted to take money out of the conversion to pay the income taxes on the conversion. In addition to lowering the value of your retirement nest egg, taking money out of the conversion, even to pay income taxes, results in an early withdrawal penalty unless you are over 59 1/2 years old. Therefore, consider using other sources of funds to pay the income taxes from your traditional IRA conversion.
In limited circumstances, you cannot deduct your contribution to a traditional IRA. If you still put money into the traditional IRA, you make a nondeductible contribution. When the traditional IRA you convert to a Roth IRA contains nondeductible contributions, you do not have to include the value of those contributions on your income taxes. For example, if you convert a traditional IRA of $20,000, $5,000 of which are nondeductible contributions, you would only pay income taxes on $15,000 of the conversion.
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