Overlooked Tax Consequences of Converting a Traditional IRA to a Roth IRA

Converting a traditional IRA to a Roth IRA can have unintended tax consequences. Generally speaking, you have to pay tax on any money you convert into a Roth and you have to pay that tax the year you convert. You simply add it to your income and it will be taxed at your highest marginal rate. Ouchie.

In 2010, there is a special provision. If you convert to a Roth this year, you can pay the tax in 2011 and 2012. If you go that route, you’ll pay the tax rate in effect at that time.

The Roth IRA guru is Ed Slott. He’s written a number of books on Roths that I highly recommend if you are interested in the subject. Ed wrote an article for a trade magazine this week (Investment News) and made an excellent point which folks often forget about.

He pointed out the danger of using IRA money to pay the tax – and I agree with Ed. He argues that if you have to use your IRA to pay the tax on the conversion, you probably shouldn’t do the conversion – however, I don’t want to get into that argument right now (even though I completely agree with him!).

What I wanted to get to was the situation when the person who converts the IRA into a Roth is under age 59 ½ and is going to use the IRA to pay the tax. This is a terrible idea. (It’s almost as bad as selecting the wrong Roth IRA beneficiaries.)

While this person won’t pay any premature distribution penalty on the converted money, because of IRA restrictions she will absolutely pay a penalty on the amount used to pay the income tax. Let me use an example.

Let’s say you convert $100,000 from you IRA into a Roth. You are 55 years old. For illustration purposes, let’s say you want to pay all the tax this year. Assume your tax liability for the conversion is $30,000.

If you take that $100,000 and use $30,000 of it to pay the tax, you’ll roll $70,000 into the Roth and send $30,000 to the IRS. You’ll also have to pay them $3,000 in penalties.

Why?

Because the $30,000 you “spent” on taxes is a premature distribution. It’s not being converted to a Roth, so you are subject to the penalty.

Conclusion?

Follow the Pilgrim. If you convert your IRA into a Roth (something I’m not sure you want to do anyway), only do it if you have funds outside your IRA to pay the tax. This is especially important for people under age 59 ½. Also, make sure that if you do go this route, you consider all the different places to open your Roth.

Roth IRA college savings is another approach you can take that actually DOES make sense if you are interested in the Roth.