One of the costs of converting a Traditional IRA to a Roth IRA is the amount you’ll pay in taxes. In some cases, those taxes can be a heavy burden, especially if you’ve been diligent about building a balance in your traditional IRA. Fortunately, there is a way to limit your tax liability when you convert to Roth. Instead of converting the entire traditional IRA at once, you can do a series of partial conversions. Consider working with a Financial Advisor to help make sure you’re handling your tax-advantaged accounts in the smartest way.
Basics of Roth . Conversion
There are two main reasons to Convert Traditional IRA to Roth IRA. One is that you can withdraw the money then tax free, and the second is no Mandatory minimum distribution. Keep in mind that early withdrawals (before age 59.5) from a Traditional IRA are subject to a 10% penalty. When you’re converting from a Traditional IRA to a Roth, you’ll want to make sure you do so in a way that doesn’t cause penalties. You have 60 days to convert if you transfer money. It’s generally safer to let your broker(s) handle the conversion, so don’t forget to include a 60-day deadline.
Remember that the money in your traditional IRA has not yet been taxed. Opinion Roth IRA is money already taxed will grow tax free. So to convert your Traditional IRA to a Roth IRA you will have to pay ordinary income tax on your Traditional IRA contributions during the conversion year before they “count” as Roth IRA funds. The taxable amount you convert to Roth will be added to your taxable income for that year and taxed at the appropriate rate.
Performing partial Roth . conversion
Just as dollar-cost averaging helps ensure that you don’t buy high and sell low, a common mistake some retail investors make – performing a series of partial Roth conversions can can help cover up what you’ll owe the government in taxes, follow the morning star. The point is to convert just enough each year to keep you from being pushed into a higher tax bracket.
For example, in 2022, a married couple earning up to $178,150 would be in the 22% tax bracket. But the couple would be in the 24% tax bracket if their total taxable income was between $178,151 and $340,100. Now, suppose that in 2022, they have taxable income of $125,000; a 22% tax on that amount is $27,500. If they convert Traditional IRA with a balance of $115,000 for a Roth, that would result in their taxable income increasing from $125,000 to $240,000. That puts them in the 24% and 24% tax brackets of $240,000 which is $57,600.
For now, however, let’s say they decide to convert Roth partially. Instead of converting the entire $115,000 traditional IRA to Roth, they only converted $50,000. That leaves their taxable income at $175,000, still in the 22% tax bracket. The 22% tax on $175,000 is $38,500 — far less than the $57,600 they would owe if they converted the entire Traditional IRA into a Roth.
Consider partial conversion
Obviously, part Convert Traditional IRA to Roth IRA, done correctly, allows you to avoid unnecessary federal taxes. But besides this obvious benefit, there are a number of challenges that need to be considered in your decision to make a partial conversion.
For example, what are the relevant state taxes? If you’re moving to a state with a higher tax rate, you’ll need to consider that when calculating your Traditional IRA amount to convert. Second, how much will you earn in a calendar year? That can be difficult to predict, especially if your compensation depends on commissions or if you can get a bonus or you plan to exercise incentive stock options.
Finally, keep in mind that extra income from a Roth conversion could result in you losing the allowance you were entitled to as part of the Affordable Care Act.
bottom line
The main reason to consider a partial Roth conversion is to control future tax liability. You do this by “filling” your current tax bracket to limit your taxable income to the maximum of the current tax bracket. This is sometimes called tax bracket differencePay your taxes now at a lower rate than you’ll pay at a future date.
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