IRA Roth Conversion Tax – Do This or Else

by Neal Frankle, CFP ®

If you decide that it makes sense to do a conversion to a Roth IRA, you need to pay your IRA Roth Conversion tax the right way if you want to avoid penalties. That’s right. Not only do you have to pay “the MAN,” but you also have to do it the way he tells you too. Sorry, that’s life.

This is especially important if you converted last year. That’s because you have an option between paying all the tax before April 18 this year or splitting your tax liability over 2011 and 2012. How do you tell the IRS what you’re doing? The last thing you want is IRS trouble.

In most cases, the way you do that is to complete Part II of Form 8606. Be careful when filling out this form. You’ll see that Line 19 is where you note the taxable amount you want included in your 2010 taxable income. If you are opting for the 2011 / 2012 split, put a zero there or leave it blank. If that’s the way you’re going, put half the taxable conversion on line 20a and the other half…you guessed it…on 20b. That tells Uncle Sam how much to include in your tax return for 2011 and 2012.

Now, if the money you converted into a Roth came from a company plan, complete Part III of the form and forget Part II. If you converted both IRA and company plan assets into a Roth in 2010, use both sections of the form.

If you want to include all the income from the conversion in your 2010 tax return, you have to be careful. If you don’t check the box to the right of Line 19, the IRS is going to assume you want to split the tax over the next two years. (In effect, this sets up an automatic IRS tax debt.) That’s the procedure for folks with money that came from an IRA, SEP, etc. If the converted Roth money came from a company plan, go back to Section III and check off the appropriate box.

One last tip. This Form 8606 is for each person who made a Roth conversion. So if you converted into a Roth last year, you have to fill out this form, and if your spouse also did a conversion, he has to complete a separate form as well. Of course, that means each of you can decide how you want to pay the tax on your conversions as you like. If you are married, you could pay all the tax this year and your husband could pay the tax in 2011 and 2012. Effectively, that means you split your tax over a total of three years.

The IRS is a huge institution and not too forgiving when you make small clerical errors. Be careful to report your Roth IRA conversion carefully. The devil is, as always, in the details.

 

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{ 2 comments… read them below or add one }

Neal@Wealth Pilgrim March 29, 2011 at 8:06 AM

Joe,

Thanks for this excellent tip. I know who I’m calling next year to do my taxes!

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JoeTaxpayer March 29, 2011 at 4:16 AM

Neal, my man, how can I see this title and not read every word? Beautiful article.

One bit of advice, if I may add – when using software (such as TurboTax) to do this, it walks you through entering the data correctly, but you still have to know how to answer its questions about what you converted and if you recharacterized any of the funds. A review of your tax forms should confirm it’s all done right.

One neat trick to decide whether to recharacterize (change some of the conversion back to traditional IRA money) is to fake $100 of the recharacterization. See how this impacts your taxes. If you thought you were in the 15% bracket but this shows a $25 difference, maybe you converted too much.
The 11/12 splitting was interesting but ignored people’s desire to actually convert a bit in 10 as well. That’s too bad.

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