Roth conversion season is in full swing. Remember, 2010 marks the first time since Roth IRAs were introduced back in 1998 that people earning more than $100k can convert their IRAs and other eligible retirement accounts to a Roth IRA. Plus, anyone who converts their retirement savings to a Roth IRA this year has the option of reporting that income on their 2010 return, or splitting the income equally over the subsequent two tax years.

During this past winter, I heard from a handful of clients who began the process of converting some of their retirement accounts to a Roth IRA, and was surprised by one specific issue that many of those clients called me to discuss. Apparently, certain financial institutions seem to be recommending that their customers elect to withhold federal and state income taxes on the money being converted.

If you plan to convert, please be aware that withholding income taxes on a Roth conversion is a huge pitfall. While you’ll owe income taxes on the amount converted, you don’t owe the 10% early withdrawal penalty on money rolled into your Roth account within 60 days. Since any money withheld for taxes is not deposited into your Roth account, expect to pay income taxes plus a 10% early withdrawal penalty on the taxes withheld.

According to theIRS in Publication 590 on Individual Retirement Accounts:

You can withdraw all or part of the assets from a traditional IRA and reinvest them (within 60 days) in a Roth IRA. The amount that you withdraw and timely contribute (convert) to the Roth IRA is called a conversion contribution. If properly (and timely) rolled over, the 10% additional tax on early distributions will not apply.

You can roll over part of the withdrawal into a Roth IRA and keep the rest of it. The amount you keep will generally be taxable (except for the part that is a return of nondeductible contributions) and may be subject to the 10% additional tax on early distributions.

Another huge problem with having taxes withheld on the Roth conversion is that you end up with less money within your retirement savings accounts following the conversion. Unless the money will remain invested for decades, wouldn’t you be better off having 100% of your money growing tax-deferred within your IRA than having 75% of your money growing tax-free within a Roth IRA?

As part our revised 2010 Roth Conversion Quiz, we include whether you have enough money to pay the taxes due on the Roth conversion as one of the ten criteria to consider prior to converting. Please note that our Roth Conversion quiz is like golf where the lower the score the better. Let’s take a look at question number 4 from the Quiz as reprinted below:

Question 4: How will you pay the taxes that will be due in connection with the conversion? Remember, the taxes on the 2010 conversion can be spread over two years starting in 2011.

  • You currently have enough money sitting in a savings account to pay the taxes that will be due. (2 points)
  • You will be able to adjust your withholding at work to cover the additional taxes that will be due without impacting your family budget too badly. (4 points)
  • The money needed to pay the taxes is fully invested in stocks and mutual funds. To pay the taxes that will be due,¬†you will need to sell some of those investments. (6 points)
  • You will not be able to come up with the money to pay the taxes on the conversion without withdrawing money from the Roth IRA. (8 points)

60 Day Solution

What happens if you already converted your IRAs to a Roth IRA, and you elected to have taxes withheld? If 60 days have not elapsed from the date of the conversion, you can transfer money from your non-retirement savings account into the Roth IRA to cover the taxes withheld. When you complete your tax returns next winter, you’ll get back those taxes withheld on the Roth conversion.

De-Convert If Necessary

If more than 60 days have passed, or you do not have the money to repay your Roth account for the taxes that were withheld, you can always undo the Roth conversion. Just make sure that the financial institution reverses any taxes that were previously withheld.

And don’t forget that you are not allowed to reconvert your recharacterized IRA account during the same calendar year. According to the IRS, “You cannot convert and reconvert an amount during the same tax year or, if later, during the 30-day period following a recharacterization. If you reconvert during either of these periods, it will be a failed conversion.”

!-- Global site tag (gtag.js) - Google Analytics --