Welcome back from Part 1 so that I can bring up a few more points that you really need to consider before converting that traditional IRA to a Roth.
It is not advisable to have income tax that will be owed withheld from the Roth IRA conversion transaction. Reason one is that the money withheld reduces the conversion amount. For example, the taxpayer wants to convert a $100,000 IRA and withhold $20,000 for taxes. In this case the conversion amount is only deemed to be $80,000 and the $20,000 represents an immediately taxable distribution.
The next reason that may apply in the example from the above is that if the taxpayer is not 59 ½ when the conversion occurs the amount withheld may be subject to the 10% early distribution penalty, unless the IRA owner qualifies for an exception to the penalty.
A rather subtle mistake that can be made is one of forgetting to consider the possibility of a recharacterization after the traditional IRA to Roth conversion has taken place. An example can best demonstrate my point. Assume a traditional IRA valued at $100,000 is converted to a Roth. That would be the amount to be taxed. Now sometime later in the year the market value of the Roth IRA has fallen to $60,000. Nevertheless, your tax liability is based on the $100,000 at the point of conversion. So would you believe the IRS is willing to help you eliminate that tax burden? The tax benefit is that the conversion to the Roth IRA can be reversed, hence recharacterized, if it is done by your tax filing deadline for the tax year you did the original conversion, including extensions. That move could avoid the payment of unnecessary taxes.
At this point I hope that it has become somewhat apparent that the conversion is not such a “slam dunk” as they say in basketball terms. Let me be clear, however, that it would indeed be a mistake not to at least consider doing a Roth IRA conversion. It does require careful planning and analysis and it is important that you thoroughly review the implications for you with your tax and financial planning advisor. It could be that a series of partial conversions may be one of the solutions for the best results in your particular case. The bottom line….You Need To Do Your Homework!
To Convert Or Not To Convert…A Roth IRA! (Part 1 of 2)
