Help! How do taxes for a Roth IRA conversion work?

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Ted Valentine
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Help! How do taxes for a Roth IRA conversion work?

Post by Ted Valentine »

I have an traditional IRA rollover from a teacher's pension plan that came from two separate jobs that were rolled out after leaving each job. The balance is about $11,000 in American Funds B shares mutual funds. The average ER is a happy 1.46% (ouch). Obviously, I want to roll this over to a lower cost option using Vanguard index funds.

What would be involved in converting this is to a Roth IRA? What are the tax implications if I convert it to a Roth? How do I figure out how much tax I will pay? Is there back SS and medicare taxes involved? What about if one of the pension rollovers came from a state with an income tax?

I'm in the 15% marginal tax bracket, FYI, married, and mid 30s. I figure it makes sense to convert it now. I don't anticipate my tax bracket will go below 15% in my lifetime and there is a good chance it will go above it in the future. At least that's the plan. Converting it seems to be a good idea (thanks to Boglehead Laura for the idea). I just want to make sure I'm not going to be hit with a lot of taxes and penalties come 4/15/08.

PS - I just ran a test 1040 using this year's numbers for standard deduction, exemptions and a $3000 child tax credit. I've already withheld enough Federal Tax to meet my income tax for 2007. No state tax here in TN.

Thanks.
xenial
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Re: Help! How do taxes for a Roth IRA conversion work?

Post by xenial »

Ted Valentine wrote:What would be involved in converting this is to a Roth IRA? What are the tax implications if I convert it to a Roth? How do I figure out how much tax I will pay? Is there back SS and medicare taxes involved? What about if one of the pension rollovers came from a state with an income tax?
Contact the custodian you want for the Roth IRA (e.g., Vanguard) to initiate the conversion process. You'll pay federal ordinary income tax on the amount you convert, but no back SS, Medicare, or state taxes in your situation. See 2006 IRS Publication 590 for details.

Best wishes,
Ken
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Ted Valentine
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Re: Help! How do taxes for a Roth IRA conversion work?

Post by Ted Valentine »

Ken Schwartz wrote: Contact the custodian you want for the Roth IRA (e.g., Vanguard) to initiate the conversion process. You'll pay federal ordinary income tax on the amount you convert, but no back SS, Medicare, or state taxes in your situation. See 2006 IRS Publication 590 for details.

Best wishes,
Ken
Ken,

Thank you for the link and response. I read that publication and it makes my head spin. If you know, can you tell me what page says how the conversion will be treated for tax purposes.

Taking what you said, assuming the amount of the IRA when it is converted is $11,000 and I'm in the 15% marginal tax bracket, I would have to pay $1,650 in Federal Income tax and nothing more to make the conversion to Roth, correct?
stebul
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Re: Help! How do taxes for a Roth IRA conversion work?

Post by stebul »

Ted Valentine wrote:Taking what you said, assuming the amount of the IRA when it is converted is $11,000 and I'm in the 15% marginal tax bracket, I would have to pay $1,650 in Federal Income tax and nothing more to make the conversion to Roth, correct?
That's a good starting point. However, the additional $11K in income could push you into the next tax bracket so the tax owed could be a little more. No SS or medicare taxes to worry about. No penalties, either, just make sure you do a rollover not withdraw the funds.

I would recommend doing this in two steps. First, rollover your Traditional IRA from the current brokerage or mutual fund company to Vanguard (leaving it as a Traditional IRA). Once that is done and cleared, have Vanguard convert the Traditional IRA to a Roth IRA. This may be overly cautious, but it helps simplify things for both the current mutual fund company and Vangaurd. They do rollovers and conversions all the time.

Is this the only Traditional IRA / Rollover IRA you/your wife have?
Is your household income less than $100K?
Do you file a Joint tax return?

If the answer to all of the above is yes, you can do the conversion. If the answer to one of the above questions is no, you'll have to give us some more details.
xenial
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Re: Help! How do taxes for a Roth IRA conversion work?

Post by xenial »

Ted Valentine wrote:Taking what you said, assuming the amount of the IRA when it is converted is $11,000 and I'm in the 15% marginal tax bracket, I would have to pay $1,650 in Federal Income tax and nothing more to make the conversion to Roth, correct?
I believe what you've stated is correct, assuming the conversion income doesn't push you into a higher tax bracket. Here's a link to the fairmark.com Guide to Roth IRA Conversions.

Best wishes,
Ken
earlyout
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Regular Income

Post by earlyout »

Ted,

The amount your convert from a traditional to a Roth IRA will be treated as regular income by the IRS. If it will push you into the 25% bracket you may want to consider converting only part of it this year and do the rest next year. There is no FICA tax on the conversion amount. Fairmark has a good discussion of IRA conversion.

EO
rocket
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Post by rocket »

The IRS's plan is that you come out even after switching from a traditional to Roth. If you have a gain somewhere is it might be because of an assumption you made.
Jack
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Post by Jack »

Ted, if you want to run a test case, you just enter the amount converted on line 15a of your Form 1040. You will get a 1099-R from from your IRA trustee in January that indicates the amount of your distribution. Assuming all of your IRAs are pre-tax, then the full amount of your conversion is taxable on line 15a. As you can see from your 1040, the amount of the conversion is treated simply as regular income. You probably want to tune the amount you convert in any one year so that you aren't bumped into the 25% bracket.
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Ted Valentine
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Post by Ted Valentine »

Thanks everyone for the warning me about the tax bracket bump.

I've done a test run on the taxes and I'm pretty sure that doing this will not push me into the 25% bracket. I earn just over the the break point, but with the standard deduction and 5 exemptions ($27,600 reduction in taxable income), I'm safely below the line. Of course the market could soar before I act. :wink:

I found out that I've already withheld enough to pay my income taxes, so I will probably end up not having to write the IRS a check in April to convert.

stebul, I like your suggestion of doing it in two steps.

The IRS's plan is that you come out even after switching from a traditional to Roth. If you have a gain somewhere is it might be because of an assumption you made.
Good point. My assumption is that my SAHM wife will go back to work within the next 5 years once the little ones go to school. I think this gives a good potential for gain.
68ShelbyGT500KR
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Post by 68ShelbyGT500KR »

Is the TIRA>Roth conversion tax computed "above the line"? Ie. Before deductions/exemptions are calculated.

In other words if you are filing single the 15% break point is <$31,850. Say, I make 25,000 W-2 net base income, and I have $11,000 in AF to do a Roth conversion. That is a total of 36K ordinary income that the TIRA will be viewed as taxable.

So, 36K taxable income (W-2 and TIRA)

31850 will be taxed at 15%
4150 will be taxed at 25% tax bracket.

Is this correct? Or is the % tax computed with your deductions/exemptions?

I was under the impression TIRA>Roths were treated the same, tax wise, as cap gains from a sale of a MF under the current laws that are in effect.
Sorry about sidetracking the thread but I was thinking on converting also but I do like the 2 step approach better that stebul recommended.
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Ted Valentine
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Post by Ted Valentine »

68ShelbyGT500KR wrote:Is the TIRA>Roth conversion tax computed "above the line"? Ie. Before deductions/exemptions are calculated.

In other words if you are filing single the 15% break point is <$31,850. Say, I make 25,000 W-2 net base income, and I have $11,000 in AF to do a Roth conversion. That is a total of 36K ordinary income that the TIRA will be viewed as taxable.

So, 36K taxable income (W-2 and TIRA)

31850 will be taxed at 15%
4150 will be taxed at 25% tax bracket.

Is this correct? Or is the % tax computed with your deductions/exemptions?
Based on comments above and filling out the 1040 form the IRA conversion amount would go on line 15a. This gets added into your ordinary income on line 22. Take out any adjustments and you have adjusted gross income.

Subtract your deductions and exemptions from AGI and you've got taxable income left. Compute tax based on the tables.

In your example, for a single filer with no dependents, you have:

$36k AGI
- $ 5350 (standard deduction)
- $3400 (personal exemption)
-----------------------------------
= $27250 taxable income

Tax rates
$7825 will be taxed at 10%
$19425 is taxed at 15%
$0 is taxed at 25%.

Tax owed = $3,696.25
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diehards
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Post by diehards »

Ted

I asked VG this Mar 07 how to convert a 401K to and IRA then to a Roth IRA with both both pre-tax and after-tax contributions to my 401K. The following is VG's E-mail answer:

"Vanguard does not track the cost basis of an IRA account. The cost basis of
an IRA, if any, is determined by the amount of nondeductible contributions
placed in the account compared to the amount of deductible contributions.
The IRS requires individuals to file IRS Form 8606 each year a
nondeductible contribution is made to the IRA. By completing this form, the
cost basis can be tracked. Your after tax basis will be the same when you
rollover the 401k to an IRA.

Please note that Vanguard does not maintain the information above. If you
did not have nondeductible contributions in your retirement plan, all
contributions, rollovers, asset transfers, and reinvested dividends and
capital gains grow tax-deferred. You do not pay any taxes on any assets
within your retirement account until you process a distribution. When you
process a distribution, the distribution proceeds are subject to your
ordinary income taxes plus penalties, if applicable. Since there is no cost
basis on the distribution amount, there is no average cost calculation. You
cannot separate your rollover into pre and post tax accounts to take tax
free distributions as each distribution is taxed on a pro-rata basis.

Although Vanguard does not calculate the profit and loss on shares held
within a retirement account, you may use your past statements to manually
calculate the gain or loss on your accounts. You may locate past statements
online in the "Statements" section of our site or may call the number below
to obtain additional statements if you are unable to locate the statement
you need online. For additional information regarding calculating profit
and loss on a retirement account, you may wish to consult with a tax
advisor or visit the IRS website at www.irs.gov.

If your modified adjusted gross income (MAGI) is $100,000 or less, you may
convert all or a portion of your existing IRA plans to a Roth IRA without a
penalty. At the time of the conversion non-deductible contributions are
exempt from taxes. Deductible contributions, earnings, and capital
appreciation are taxable at your current tax rate. When computing the
taxable portion of converted amounts you will need to factor in all of your
IRA balances, not just the one you are converting. The entire tax amount is
due in the year of the conversion.

Although you should not include the conversion amount when determining your
eligibility in regard to the $100,000 limit, it does become part of your
AGI, and could increase your tax bracket. Please see IRS Form 8606 for more
information on calculating the taxable portion of a Roth IRA conversion.

Please note that you may reinvest the converted assets into the same fund
in most cases. To review which Vanguard funds are closed please see the
'Research Funds and Stocks' tab on Vanguard.com.

Through the 'Retirement' link on the 'Account Types & Services' tab of our
website, you can find detailed information on the Roth IRA and the
contribution limitations. There are also several interactive worksheets
that may be helpful to you in selecting the best retirement plan for your
needs.

To convert your traditional IRA to a Roth IRA, please complete the forms in
our Roth IRA Conversion Kit. You may obtain material through the 'Forms'
link on the top of our homepage. "

Good Luck with your Conversion :)
NASA Engineer Retired "Higher CO2 levels is natures way increasing crop yields to feed the world’s growing population"
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Ted Valentine
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Post by Ted Valentine »

diehards wrote:Ted

I asked VG this Mar 07 how to convert a 401K to and IRA then to a Roth IRA with both both pre-tax and after-tax contributions to my 401K. The following is VG's E-mail answer:

"Vanguard does not track the cost basis of an IRA account. The cost basis of an IRA, if any, is determined by the amount of nondeductible contributions placed in the account compared to the amount of deductible contributions.

The IRS requires individuals to file IRS Form 8606 each year a
nondeductible contribution is made to the IRA. By completing this form, the cost basis can be tracked. Your after tax basis will be the same when you rollover the 401k to an IRA.

Good Luck with your Conversion :)
Thanks. Can you tell me if my IRA from a school retirement plan is a deductible or nondeductible contribution? That is what confuses me about the IRS publications and that C-Y-A legal gibberish from Vanguard.
xenial
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Post by xenial »

Ted Valentine wrote: Can you tell me if my IRA from a school retirement plan is a deductible or nondeductible contribution? That is what confuses me about the IRS publications and that C-Y-A legal gibberish from Vanguard.
Normally it would be treated as a deductible contribution. The key is that while you never "deducted" the contribution on Form 1040, you presumably have not yet paid income tax on it because your employer took it from your paycheck pre-tax.

Best wishes,
Ken
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BigFoot48
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Post by BigFoot48 »

As a related question, I have most of my assets in traditional IRAs. I am retired and expect my future marginal tax rate to remain at 15%, as that income level is sufficient for my needs.

So, is there any reason I should convert some or all of my IRAs to Roths?
Retired | Two-time in top-10 in Bogleheads S&P500 contest; 14-time loser
Jack
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Post by Jack »

BigFoot48 wrote:As a related question, I have most of my assets in traditional IRAs. I am retired and expect my future marginal tax rate to remain at 15%, as that income level is sufficient for my needs.

So, is there any reason I should convert some or all of my IRAs to Roths?
One advantage of a Roth is that it has no required minimum distribution in retirement. This means that you can keep your money in a Roth longer. It may also make it easier to keep your taxes at the 15% rate if you can avoid taking unneeded distributions.
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diehards
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Post by diehards »

Patrick

My reasons to convert Traditional IRA’s to Roth IRA’s.

1) I am not required to take the Mandatory IRA Withdrawals when I turn 70 ½ with my Roth IRA.
2) My Roth IRA is the last thing to go so my kids will probably inherit my tax free Roth IRA. So I will do the Roth conversion for the kids.
3) The IRS tax rate may go up in the future. Our socialist government needs to collect more taxes for social programs.
4) I have pre-tax and after-tax contributions to my 401K now Traditional IRA so after I figure out how to complete the IRS Form 8606, I will only need to pay Fed taxes on the pre-tax percentage of my IRA to Roth IRA conversion.
5) Keeping Traditional IRA and Roth IRA are more sheltered from lawsuits. I will not take a distribution unless I need the money to live on or the Feds make me take a Mandatory IRA Withdrawal.


Like to hear what other Diehards say about reasons for converting IRA’s to Roth IRA’s?

Good Luck !
NASA Engineer Retired "Higher CO2 levels is natures way increasing crop yields to feed the world’s growing population"
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BigFoot48
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Post by BigFoot48 »

Excellent point on the minimum distribution requirement on the traditional IRA, as that is something that could push me up into a higher bracket.

And yes, I do expect either the 15% or its related dollar limits to go the way of the Doodoo bird as Big Government makes a roaring comeback.
Retired | Two-time in top-10 in Bogleheads S&P500 contest; 14-time loser
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