How Much in Taxes Will I Pay if I Convert to a Roth IRA?
Converting to a Roth IRA can be an appealing option, because it provides tax-free qualified distributions. However, the Internal Revenue Service imposes income taxes on conversions that may make a conversion unaffordable or may make it unprofitable if you expect to be in a higher tax rate in retirement.
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Taxable Conversion Amount
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The amount of your conversion usually must be included in your taxable income. For example, if you convert $50,000 from a traditional IRA to a Roth IRA, you usually have to report $50,000 in extra income on your income taxes that year. However, if you have made nondeductible contributions to the traditional IRA, those funds do not count as taxable income when they are converted. For example, if $10,000 of the $50,000 being converted was from nondeductible contributions, you only have to include $40,000 in taxable income.
Estimating Tax Liability
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The taxable amount of your Roth IRA conversion is added to your taxable income for the tax year and is taxed at your marginal income tax rate. The higher your income for the year, the higher your tax rate, because the United States uses a progressive income tax rate. For example, if you have a $40,000 conversion and your marginal tax rate is 29 percent, you owe an extra $11,600 in taxes. The income from the conversion also could push you into a higher tax bracket, a factor you should consider before making the conversion.
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Tax Reporting
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When you file your income taxes, you use Form 8606 to calculate the taxable portion of the conversion. You report the total amount of the rollover as a nontaxable IRA distribution and the taxable portion, as determined in Form 8606, as a taxable IRA distribution. Only the taxable portion is added to your taxable income total for the year. If you made an estimated payment for the taxes you will owe or had any money withheld from your conversion, include that amount as part of your taxes withheld when you file your taxes.
Payment Considerations
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When you convert money to a Roth IRA, you may be tempted to take money from your converted funds to pay the income taxes you will owe. However, this should be avoided if possible because you cannot contribute extra in future years to make up for the amount you took out to pay taxes. In addition, if you are under 59 1/2 years old at the time of the conversion, you must pay an extra 10 percent income tax penalty, because the amount you remove is considered an early withdrawal subject to a penalty even if you use it for income taxes.
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