How does one pay the income tax on the IRA conversion and how does the IRS know about the conversion? The bank or financial company that does the conversion is required by the law to report the conversion on a form called a 1099-R. The form must be mailed to you on or before January 31 of the year after the conversion. For example, for a 2010 conversion, they must be mailed to you on or before January 31, 2011. You will receive a hard copy, and the IRS gets an electronic version of it. The IRS can then track the conversion when you file your income taxes.
Prior to converting, you or your tax advisor should determine how much additional tax the conversion will create. This is done by estimating your tax liability (for federal and state) by adding the conversion amount to your estimated taxable income for the conversion year. For example, if your taxable income prior to the conversion is $80,000 then the $20,000 conversion would make your taxable income $100,000. The federal income tax will vary based on your filing status (such as single, married, etc). The Roth IRA conversion may be subject to state income tax if your income is subject to state income tax; please check with your tax advisor.
You may determine no additional tax needs to be paid because the refund you usually receive is enough to cover the additional liability. However, if you do determine additional income taxes need to be submitted, there are several ways to accomplish this:
- If your refund is not enough to pay for the conversion, you can increase the withholding from your wages or pension to pay for it. In this case, divide the additional income tax by the remaining pay periods for the tax year.
- Or, by filing Form 1040-ES Estimated Tax Voucher. In this case, the additional income tax liability would be divided by the remaining 1040-ES vouchers for the tax year. There are four vouchers per year due, as follows: April 15, June 15, September 15, and January 15 of the next year. For example, if you owe $10,000 in income tax for 2010, then you would pay $2,500 each on April 15, 2010, June 15, 2010, September 15, 2010 and January 15, 2011.
- Or, you may be able to wait and pay all or most of the income tax on the conversion by April 15 of 2011 in the above example by using one of the exceptions below.
In order to avoid paying any penalty on the income tax you would owe, you can use one of the following IRS exceptions:
1) Pay 90 percent of your current income tax amount by withholding it from your wages or pensions, or by paying estimated taxes and the remaining 10 percent by April 15.
2) If you owe less than $1,000, you will not be charged penalties.
3) Pay 100 percent of your prior year's income tax liability and pay the reminder by April 15. This is the easiest and most common exception used. For example, in 2010, you convert to a Roth IRA, and your total income tax from conversion and your other income is $15,000.00. Assume your income tax for 2009 was $7,000.00. As long as you pay the $7,000 in income tax during 2010, then you can pay the remaining $8,000 by April 15, 2011. You then will have avoided any penalty. What if for 2010, your income tax withholding is only $6,000? As long as you pay the additional $1,000 during 2010, by either withholding additional tax from your wages or pension, or using Form 1040-ES, you will avoid any penalties. This exception is how most retirees and self-employed individuals pay their income taxes.
4) The following method is very seldom used. However, for a Roth IRA conversion, it will become more common. This exception is based on annualized income. It is used when your income varies every quarter. So, the date the conversion is complete determines when the estimated income tax is due. Under this method, you need to pay 90 percent or more of the total taxes during the year. If the conversion happens before April 1, then you need to figure the estimated income taxes and pay it over all four quarters. If the conversion were between April 1 and May 31, then half of the estimated income tax would be due on June 15. The remaining estimated income tax would then be split and due on September 15 and January 15. If the conversion happens between June 1 and August 31, then three-fourths of the estimated income tax is due on September 15, and the one-fourth would be due on January 15. If the conversion happens between September 1 and December 31, then your entire estimated income tax is due on January 15. Again, the remaining 10 percent of income tax can be paid by April 15 without any penalty.
As you can tell, this method can be complicated. I will explain it in an example. Let's say the total estimated income tax on your conversion is $13,333. Then, you must pay 90 percent or $12,000 in estimated income tax. If your conversion happens before April 1, then you would pay $3,000 each quarter. If conversion happens between April 1 and May 31, then you would pay $6,000 on June 15 and $3,000 on September 15 and January 15. If conversion happens between June 1 and August 31, then you must pay $9,000 by September 15 and $3,000.00 by January 15. If the conversion happens after August 31, then you must pay the estimated tax of $12,000 by January 15.
You always have the option to pay all the estimated income taxes at the time of conversion. Again, if you convert in 2010, you have the option of adding the entire conversion amount to your 2010 taxable year, and paying all the income tax in 2010.
The other option that is available only for the 2010 tax year is to pay the income tax in 2011 and 2012. If you choose to pay the income tax in 2011 and 2012, then you add half of the conversion amount to each year and pay the income tax based on each year's tax bracket. For example, if you converted $20,000 in 2010, then you can either add the $20,000 to your 2010 taxable income and pay the income tax in 2010, or add $10,000 both to your 2011 and 2012 taxable income and pay the income tax in 2011 and 2012.
If converting after 2010, you will pay the income tax on the entire conversion amount in the year of conversion. Because you will be able to split the income tax payment into two years, I believe there will be many people converting in 2010.
Based on the due dates of the income tax payment, it appears to be advantageous to convert after August 31 and pay the income tax one time by January 15. However, the sooner you convert the sooner your investment will grow tax-free.
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