Author Topic: Traditional IRA conversion  (Read 1414 times)

IdahoMMM

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Traditional IRA conversion
« on: December 15, 2014, 04:42:55 PM »
My wife and I have some traditional IRAs that have mostly nondeductible contributions -- silly income restrictions made them nondeductible. I'm trying to decide whether it's worth it to convert them to Roth IRAs. Here's the info:

Contributions: 42,000
Deductible contributions: 500
Nondeductible contributions: 41,500
Current value: 55,852
Earnings: 13,852
Taxable income (earnings plus deductible portion): 14,352

Assuming a 30% tax rate, I'm thinking this will generate an additional tax liability of 4,305.

If you had the cash to pay the extra tax bill, would you convert these now? It seems like it's pretty easy to switch assets at the IRA custodian, but what sort of reporting obligations will I have? Could this trigger underpayment penalty, and if so, should I plan this for a future year instead of knocking it out before the end of 2014?

Any advice or ideas appreciated!

secondcor521

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Re: Traditional IRA conversion
« Reply #1 on: December 15, 2014, 07:20:16 PM »
Hey, a fellow Idahoan.  Hi there :-)

Without additional information about your goals, risk tolerance, other assets, age, and probably a million other things, I can't tell you what you should do.

I was in your shoes, however, and in my case what I did was roll the earnings and deductible contributions into my 401k, and then roll the nondeductible contributions to my Roth IRA at zero tax.  I would rather avoid paying 30% income tax ever, so my plan involves retiring early and withdrawing from my pre-tax funds at a very low annual rate (maybe $35K annually), which will generate a very low tax bill, if any.

Regarding your second question, you will need to fill out Form 8606.  It's a little tricky, but if you know the nomenclature and how the taxes should work, you can muscle your way through it.  At the end of the day you'll fill out part II for the actual conversion, and that will create a taxable amount that will end up on line 15b of your 1040.

Yes, it could trigger an underpayment penalty.  One way that I successfully avoided an underpayment penalty in a previous year was making an estimated tax payment by 1/15, which was included in my total taxes paid and, in my particular case, got me within the $1,000 safe harbor amount.  So if you want to do the conversion, the underpayment penalty shouldn't really be an issue as long as you're willing to do a pro-forma run of your taxes around the new year and send in a check to get you within the safe harbor limits.

Assuming your an Idaho resident, you will also pay ~8% to Governor Otter on the converted taxable amount, so you should figure that into your plans.  Last time I looked you were safe from an underpayment penalty to the state if you had paid at least 80% of the taxes owed, so there is a wider safe harbor there.

I guess I wonder why you are so eager to pay 30% in taxes now.

bogart

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Re: Traditional IRA conversion
« Reply #2 on: December 15, 2014, 08:16:43 PM »
If you are planning to FIRE and live on lowish amounts (by taxable standards) it probably doesn't make sense to convert.  Do it later when you're in a lower tax bracket.

If you're not so interested in the RE stuff (as I'm not) and anticipate your income remaining high for years or in perpetuity, you may well be better off taking the tax hit now on the roughly $15K amount, rather than waiting until you have lots more earnings and then doing the conversion of a larger amount.


IdahoMMM

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Re: Traditional IRA conversion
« Reply #3 on: December 17, 2014, 04:55:30 PM »
Thanks for the help putting things into perspective. 2Cor: your last line states it best -- I'm not sure why I am eager to pony up 30% in taxes now. My thinking was that if I put a lot more into nondeductible traditional IRAs over the next years, since that's really the only way I can put money into an IRA for now, the income generated during the eventual conversion will only get larger. But as you and bogart point out, if I do the conversion later the amount might be larger but the tax rate will be lower.

I think I'll stay put for now, but I thank you for your advice!