A common mistake many people make with Roth IRA conversions prior to age 60 occurs when they withhold taxes to pay for the conversion. At Almega Wealth Management, we recommend NOT withholding taxes from the conversion and instead paying the taxes with cash on hand.
Before proceeding further, please note that this article only addresses mistakes made by people executing Roth conversions prior to age 59½. If you are over age 60, this common mistake does not apply to you.
The Mistake
Let’s examine a scenario: You’re converting $30,000 from your Traditional IRA (or pre-tax 401k) to your Roth IRA. For tax purposes, assume you’ll be in the 12% Federal marginal tax bracket for the tax year and 2.5% for state income tax.
When you enter the conversion into your brokerage account to convert $30,000 and elect to have Federal taxes withheld at the 12% tax rate and 2.5% for state tax, the total amount actually deposited into your Roth IRA is $25,740. The difference is withheld for taxes.
When completing your tax return, you will report a $30,000 distribution from your Traditional IRA. Because you are under 59½ years of age, you must also calculate how much of the distribution is subject to a 10% premature withdrawal penalty. Many people assume the 10% penalty doesn’t apply because they didn’t “withdraw” money but rather converted it. However, they discover that the withholding is subject to the 10% premature penalty because those funds weren’t converted to the Roth IRA.
Instead of owing $4,260 in taxes, you end up owing $4,686 because the 10% penalty is assessed on the tax withholding. While the difference in our example may seem small at only $426, that’s money you’ll have to pay to the IRS for no value received.
The Solution
To avoid this common mistake with Roth IRA conversions prior to age 60, we recommend NOT withholding money for taxes and instead paying the tax from your personal savings.
This approach offers two benefits:
- It avoids the 10% early withdrawal penalty that may be applied to the tax withholding
- It allows you to convert more money to the Roth IRA, which is mathematically advantageous in the long run
However, this can lead to another tax consideration: you may be subject to a penalty for the underpayment of estimated taxes if you haven’t paid enough to qualify for safe harbor protection.
The safe harbor rules for the underpayment of estimated taxes require you to pay either 90% of your current year’s tax liability or 100% of your previous year’s tax liability. In a year when you haven’t met the safe harbor protection and convert money from your Traditional IRA to your Roth IRA, you could become subject to the penalty.
Since underpayment penalty rules can be complex and are beyond the scope of this article, we suggest two approaches to avoid any penalties:
- Convert money to the Roth IRA in the first quarter of the year and immediately send the IRS a check (via Form 1040-ES) before the first quarter estimated payment deadline.
- If you don’t convert in the first quarter, you have two options:
- Send in the estimated payment immediately to stop the accrual of the underpayment penalty
- Distribute from your Traditional IRA the taxes due on the conversion (via a separate transaction) and withhold 100% for taxes. Then immediately deposit the money back into your Traditional IRA via a 60-Day Rollover (limited to once per year) from your personal checking or savings account
This strategy of withdrawing the taxes and immediately returning the money avoids both the 10% premature penalty and the underpayment penalty.
The Impact of Professional Guidance
In financial planning, small incremental improvements make a significant difference. Working with a financial planner who understands the nuances of the tax code is crucial. This article demonstrates the complexity of the tax code as it applies to financial planning decisions.
At Almega Wealth Management, our team of financial planners and tax professionals work side by side, coordinating these decisions for our clients. We pride ourselves on being the difference the difference makes for our clients and the generations that will follow.