If I Do The Roth Conversion, Can I Finance The Tax Payment?
Okay, we’re putting the cart before the horse here, as the saying goes.
I assume you’re at least a bit read up on how conversions work or you wouldn’t have this question, but since I really shouldn’t assume anything, a brief review is in order first. If you don’t think you need the review and just want the question answered, skip down seven paragraphs….at your own risk, of course. ?.
Prior to 2010, converting from a Traditional IRA or an old company 401(k) was severely limited, in that if you, or you and your spouse, depending on how you file your taxes, made anything in excess of $100,000, conversion was not allowed. As of 2010, that restriction has been removed, so that effectively means that anyone can convert. The next question is whether or not converting makes sense for you. In 2010, as it has always been since the creation of the Roth IRA, you are allowed to make a conversion from your Traditional IRA….if you are willing to claim all of those converted dollars as additional income. That’s not different this year. What is different is that, for tax year 2010, while you convert the money and start growing it tax-free, you don’t have to claim the income right away. Wow, that’s huge! (Okay, it’s huge to me, but that’s because I’ve done the long-term math).
Don’t get too excited, because you DO have to claim the income though. The cool thing is that you get to wait until tax year 2011, due in April 2012, when you have to claim ½ of the total converted amount. Then, you get to wait until tax year 2012, due in April 2013, when you have to claim the other ½ of the total, even though you can have the benefit NOW. That can significantly reduce the amount of tax you have to pay each year, depending on your other possible sources of income and deductions, and it’s (as of this writing) NOT TRUE for any year after 2010. Okay, now that we’ve gotten past the cool things that current law allows, let’s figure out if you can and should finance the tax payment from your Traditional IRA or 401K.
The simple answers are that yes, you can, although, no, you probably shouldn’t. Here’s why. If you finance the tax payment, what you’re really doing is taking money from your existing retirement savings to pay a current bill, and that should raise a big red flag for you. Unless you really have no other choice due to economic hardships, paying any current bill from retirement funds means you probably can’t afford it and need to take a hard look at your budget. There are a few rare exceptions, but they go beyond this topic by a long way.
In the final examination of any conversion, you have three options:
1) Leave the Traditional IRA alone. This means no conversion taxes, and IF personal tax rates don’t go up very much, the maximum possible distribution in the future.
2) Convert the Traditional IRA to a Roth IRA, and as the subject of this article addresses, “finance” the tax payment by taking a distribution of the account value. Yes, this does pay your taxes, but it does two very negative things. It reduces the amount you have saved for retirement, which reduces the amount of compounding that will happen between now and retirement, no matter how old you are. It can also mean that you will have to pay a penalty of 10% on TOP of the taxes, if you’re taking this distribution prior to being age 59 ½. Oh yeah, and it also means that you give up most of the conversion benefit because by taking the distribution now, those taxes and penalties are added to 2010, which hopefully is NOT your objective.
3) Convert the Traditional IRA to a Roth IRA, and pay the taxes from outside the IRA. This is almost always the best option, because your retirement account balance doesn’t get reduced by a distribution (there being no distribution), and THAT means no penalty no matter your age. So, why not pick choice 3? Well, if taxes don’t go up, then the tax advantage of having the money to withdraw tax-free is probably reduced, plus you’re out the money from some other source now. What makes that risk considerably less is the possible gain you get in 2010 from being able to defer those taxes a few years. This is a pretty complicated topic for most of us, but fortunately I have a tool that can create personalized answers for you.
If you’re serious about considering this, and would like to know specific details about what you should consider doing, call me. Want to know more? Let’s talk, and create a plan that’s right for you and your family.
Email me: John@FinancialIdeasBlog.com
Related posts:
- Having A Smart Nest Egg!
- What’s Wrong With Getting A Big Tax Refund?
- What Kind Of Money Should I Put Away Before 2010?
- How To Handle A 401(K) Rollover To IRA
- The Roth Conversion Opportunity (And Why It’s So Cool)!
