Roth Conversion Help

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tman9940
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Joined: Tue Aug 11, 2015 11:44 pm

Roth Conversion Help

Post by tman9940 » Sun Jul 16, 2017 9:12 pm

I am thinking about converting my traditional IRA to my Roth. I've never done this before. Trying to figure out if it is worth it. I am currently 31. If I read correctly, there is no 10% penalty for an "early withdrawal" since the traditional will be converted? When and how do you pay the tax on the conversion? When the money is converted, is it transferred into my existing Roth IRA or does it become a separate account? My traditional is significantly smaller than my Roth. I currently have VISGX (Small Cap Growth) in my Traditional. Does that fund go into my Roth, or does the money go to the existing fund (VTSAX) in my Roth? I'm sure I have more questions, but this is all I can think of at this time. Thanks for any and all info! Trying to see if this would be worth it, and would love some people with similar experience to chime in. Thanks!!

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FiveK
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Re: Roth Conversion Help

Post by FiveK » Sun Jul 16, 2017 11:16 pm

tman9940 wrote:When and how do you pay the tax on the conversion?
The amount converted is treated as ordinary income, so you add that to whatever else you earn this year and pay tax on all of it.

Because the converted amount comes on top of your other earnings you would likely pay your highest tax rate on that amount. Consequently, for most people doing Roth conversions while working is not a good idea. But it depends on your specific situation.

See Traditional versus Roth - Bogleheads for more.

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celia
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Re: Roth Conversion Help

Post by celia » Mon Jul 17, 2017 2:18 am

tman9940 wrote:If I read correctly, there is no 10% penalty for an "early withdrawal" since the traditional will be converted?
There is no penalty since the money is still in an IRA. It is best to convert at the same custodian the traditional is at, so you don't take possession of the funds, as that can cause complications.
When and how do you pay the tax on the conversion?
The amount converted is taxed on your federal and state income taxes at the same rate as if it is "wages" for this year. If you have tax software, add the amount of the planned conversion to your wages to get a quick estimate of what your federal and state taxes would jump to (using a copy of last year's data file). [For your real return, you will get a Form 1099-R at the end of the year and the data will end up on line 15a and 15b instead.] Can you afford the taxes? If not, you can convert just a part of it this year and maybe a part next year. You may then want to update your tax withholdings for the remainder of the year. Don't withhold taxes from the converted amount as that would be a permanent "loss" in your tax-advantaged space. A tax withholding would also be a distribution going to the IRS, that would not only be taxed, but would incur the 10% early withdrawal penalty if under 59.5
When the money is converted, is it transferred into my existing Roth IRA or does it become a separate account?
You can request either but I strongly recommend you convert into a new (empty) Roth so that recharacterizations will be simpler, if needed. You will likely want to recharacterize if the stock market goes down significantly and then don't want to pay taxes on an amount that is worth a fraction of the conversion. If you recharacterize, the money goes back to the traditional IRA like it never happened and after 30 days or in the following year (whichever is later), you can re-convert. If the value is still low at that time, you will end up paying less on the conversion taxes in that year. You can recharacterize conversions done this year up until October 15 of next year. After then, they are "keepers" and can be moved to your primary Roth.
My traditional is significantly smaller than my Roth. I currently have VISGX (Small Cap Growth) in my Traditional. Does that fund go into my Roth, or does the money go to the existing fund (VTSAX) in my Roth?
You can put the converted money into anything you want in the Roth account, VISGX, VTSAX, or another fund. If you want to keep the same Asset Allocation you currently have, just keep it invested in the same fund.

It can seem daunting the first time you convert or recharacterize, but the following times will seem easy. The important thing is to not take possession of the funds and to keep them separate from other Roths you have, in case you recharacterize. If you combine it in an existing Roth, even in a separate mutual fund, everything in that account will be considered co-mingled. Then when you recharacterize, the value that goes back will not be like you expect.

vtMaps
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Re: Roth Conversion Help

Post by vtMaps » Mon Jul 17, 2017 2:35 am

As celia mentioned, do the conversion into an empty account. Specify NO withholding on the conversion, and pay the tax with separate funds.

You may wish to do multiple smaller conversions (each into an empty account). For example, you could convert a stock fund and a bond fund separately. If one of the them declines in value you can recharacterize it.

Suppose you wanted to convert $10k this year. You could do three conversions of $10k this year (various funds at various times of the year) and recharacterize the two with the least gains.

--vtMaps
The optimist proclaims that we live in the best of all possible worlds; and the pessimist fears this is true. --James Branch Cabell

tman9940
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Re: Roth Conversion Help

Post by tman9940 » Mon Jul 17, 2017 9:27 am

Thanks everyone for the replies and advice. Sounds a lot more confusing than I was hoping. I will have to research the topic some more and hopefully get it taken care of.

SGM
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Re: Roth Conversion Help

Post by SGM » Mon Jul 17, 2017 10:05 am

Did you have deductible or non-deductible traditional IRAs? This makes a difference and you would use a form 8606 if you had non-deductible IRAs. It is important to consider your tax bracket now vs. when you will start spending your IRAs in retirement.

Consider just the amount involved in the conversion in terms of purchasing power not in terms of the total amount of money you have before and after conversion. In the 25% tax bracket $10k in a tIRA has the purchasing power of 7.5k. You still have 2.5k in taxable for a total purchasing power of $10k. When you convert you have $10k in a Roth 0 in tIRA AND 0 IN taxable for total purchasing power of $10k. Conversion is a wash at the time of conversion in terms of purchasing power even though your actual totals are different (12.5k vs. 10k) . Advantages accrue over time in having less taxable dividends over time and advantages are much greater if you avoid large RMDs at age 70 1/2.

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