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Why Your Roth Conversion Could Trigger Unexpected Tax Penalties · Retirement Answers

• 0:00
  Jacob: Hey, friends, and welcome back to another episode of Retirement Answers. This week's Friday q and a question comes in from Goran, and Goran says, love your podcast and listen to every episode. Great content and presentation. I've learned a lot. Here are a couple questions for the q and a if they bring value to the show.
• 0:16
  Number one, how are dividends taxed when they are transferred from a Roth account to a brokerage or checking account and used as income? So that's question number one. We'll tackle that in just a second. And then question number two is a little more in-depth, and this will be a fun one to try to answer. But it says, if someone has a traditional IRA and a Roth IRA and is doing a partial Roth conversion, is there a pro rata rule or just paying estimated taxes to the IRS at the time of the conversion for the converted amount?
• 0:42
  Also, does it make sense to do a conversion in December so that the taxes can be paid during next year's tax filing season instead of estimating it? Alright. Here's what we're gonna do. We're gonna answer both these questions separately. I'm gonna answer the first one since it's a little bit more straightforward, and the second one does require a little more depth.
• 0:58
  So we'll restate the question on number two here just a moment we get to it, and then we'll answer that one at that time. Okay. Number one, how are dividends taxed when they're transferred from Roth account to brokerage account? It's important to understand how dividends are taxed, not necessarily because of how dividends are taxed in this situation, but because of how each account type is taxed. So if we have a brokerage account or a checking account, any sort of interest or dividends or realized capital gains that happen in a brokerage account, but just interest in a checking account, those are always taxable in that particular tax year, and then depending on the type of either capital gain or qualified dividend or non qualified dividend or interest it is, then that will be taxed either as a qualified long term capital gain or as normal income.
• 1:40
  It just depends on what type it is. Now that's within a brokerage account or checking accounts, but whenever we're thinking about traditional IRAs or Roth IRAs, you're not taxed on dividends or interest or anything like that at all because they're what's called tax advantaged or tax sheltered accounts. So if we just recap really quickly how traditional IRAs and Roth IRAs work, a traditional IRA is typically a tax deducted account, meaning all the dollars that are in that particular traditional IRA have not been taxed yet, so you've deducted that out of your income. Now you can have after tax dollars in a traditional IRA. Typically, I don't recommend doing that for different reasons that I won't get into today, but then with that traditional IRA, since the money there is tax deferred and you have not paid income taxes on it yet, whenever you distribute the money out, you will pay income taxes at that point.
• 2:26
  So you could have as many dividends or interest or capital gains within that traditional IRA for forty years and never pay taxes on any of it. The only time you pay taxes is whenever you distribute that money out in the future. Now, the Roth IRA is the opposite of that. You pay taxes on the front end before you put the money into the Roth, so it's a after tax account, and then you let that money grow and it's still tax sheltered, so any dividends or interest or capital gains that are realized in that Roth IRA, do not pay taxes on that along the way either. And so whenever you take that money out of the Roth in the future, since the taxes have already been paid on the front end, the idea with this account that makes it tax free is that you can distribute the money out tax and penalty free if the account has been open for five years and you're age 59.5 or older.
• 3:11
  Now, I've talked about Roth IRA distribution rules many different times, but really quickly, I'll just say again that any contributions that you've made to a Roth IRA, those are eligible to be taken out regardless of those two rules I just stated. So you could be any age and the account does not have to have been open for five years to take your contributions back out, what's called your principal. What that five year rule and that age requirement is actually referring to is the growth that's happening within the account. So for example, if you put $7,000 into a Roth IRA and it grows to $20,000 you can take your $7,000 out at any point no matter what your age is or how long the account has been open, but that 13,000 of growth, that is what is restricted by those two different rules, the five year rule and the age requirement for Roth IRA distributions. If you take the gains out before those two rules are met, you'll pay normal income taxes and a 10% early distribution penalty as well.
• 4:04
  So that's how a traditional IRA and a Roth IRA, the taxation works on them. So when we're talking about dividends, technically there's no issue around dividends whenever you move money from a Roth account over to your checking. So basically, you're distributing the money out of your Roth IRA to your bank account to spend. You're not paying taxes on any of that money, whether it's dividends or interest or capital gains or principal or whatever it is, so long as you're 59.5 or older. So you can take that money out, no tax, no penalty, and the same thing actually applies to traditional IRAs.
• 4:35
  Let's say you were taking money out of a traditional IRA and sending it to your bank account to be used as income. Dividends don't matter in that situation because that's just a distribution out of the account, and that's the thing that triggers the taxation component of this whole equation. So I hope that answers your question. I think, dividends are really not something that's in play there if you're making distributions from an account. It's only whenever the money is held inside that brokerage moving forward that dividends could be taxed compared to, you know, whenever they were in the Roth before and they were not being taxed.
• 5:05
  So, if you do move it from a Roth IRA to a brokerage account and you have that money remain invested in a brokerage account, then, you know, you would have taxes annually on any dividends, interest, or capital gains that would happen there. So I hope that answers question number one or at least provides some clarity around it. Now number two, this one is definitely more confusing and it's going to take a little bit longer to explain what's really going on here. So I'll restate the question and then we'll go from there. If one has a traditional IRA and a Roth IRA and is doing a partial Roth conversion, is there a pro rata rule, or just or is it just paying estimated taxes to the IRS at the time of the conversion for the converted amount?
• 5:41
  And then there's another part of the question I'll get to in just a second, but I want you to focus really quickly on answering this part about the pro rata rule. So the first part of this question. The pro rata rule only applies if there is both pretax and after tax money inside of your traditional IRA. Most of the time, people do not have after tax money in a traditional IRA, but it is absolutely possible. Maybe you were above the income limits and you contributed to a traditional IRA because that was the only place that you could and you didn't want to do a backdoor Roth or weren't able to for whatever reason, and so you put money after tax into a traditional IRA because you just wanted to save somewhere on top of your four zero one ks plan.
• 6:18
  That's one thing. But the most common issue around pro rata rule in traditional IRAs has to do with the backdoor Roth conversion. So whenever you put money into a traditional IRA to do a backdoor Roth, that is after tax money, you're not taking a tax deduction on that, but whenever you do a conversion, it has to take into account the full account and the type of dollars within that account. So for example, if you have $10,000 already in a traditional IRA that is tax deferred, let's say it's a rollover from an old job, and then you go to do a backdoor Roth contribution and you have to put the money into the traditional IRA, remember this is not a tax deductible contribution, this is after tax money going in, so you put $7,000 into your traditional IRA that also has $10,000 already in it. So now you have $17,000 bucks in the account.
• 7:04
  Out of that $17,000 though, seven is not taxable, meaning it's already been taxed. And so whenever you go to do your conversion portion of the backdoor Roth contribution, you convert, but 7,000 out of 17,000, whatever that percentage comes out to, that amount is not taxable, the other amount of your conversion amount is. So that would be greater than 50% if we're thinking about it just with the 7,000 out of 17. That'd be greater than 50% of your conversion amount is actually subject to taxation because you're actually converting part of the tax deferred money. You can't pick and choose which dollars within the traditional IRA you want to convert.
• 7:44
  Now this goes with a backdoor Roth conversion, whether you're kind of doing a backdoor contribution or just a regular Roth conversion, meaning you didn't put any money into the account in the same tax year. So in this question here, Goran, I think what you're looking at is you might be slightly confused because of some of the maybe content I put out before around backdoor Roths and the pro rata rules and understanding that correctly. If you do not have any after tax money in your traditional IRA and you're doing a partial Roth conversion, there should be no pro rata rule issues. But if you know that you do have after tax money co mingled with pre money within your traditional IRA, there will be a pro rata rule, and you will pay tax on at least a portion of the amount that you're converting. Now here's the thing.
• 8:26
  The question is, do you even know how much basis you have in your traditional IRA? And the word basis there, that's just the word for after tax money in your traditional IRA. How much is actually after tax within the account? Do you even know that? Right?
• 8:38
  Because most people don't, if we're being really honest, and so whenever you go to actually do the conversion, you get your $10.99 at the end of the year to pay your taxes with, what's going to happen is is the $10.99 is going to say that you owe tax on all of it, even if you know in your mind that you don't. It's the ten ninety nine will say that you do. You have to be able to prove that at least a portion of the amount that you converted is not subject to taxes, which means you have to have some sort of 5,498 or you have to have an 8,606 form that you've been filing year after year to keep up with your after tax basis within your account. And, again, most people do not do this correctly, so what typically is going to end up happening here is you're probably just going to pay double taxes on some of that money because you pay tax on the front end, making it an after tax contribution to a traditional IRA, and then you're going pay tax again upon distribution, being the conversion, and so you might end up paying taxes twice on those same dollars.
• 9:30
  So the pro rata rule, it really only applies if you got after tax money in the account. Again, most people don't, but if you know that you do, I'll double check your 5,490 eight's, I'll double check your form 8,600 six's and see what that shows, what is your true basis in the account. If you have no idea what it is, I would just prepare to pay taxes on all of it because if you can't prove that you have basis in the account, then you get audited, and then they're gonna make you pay taxes on that one way or another. So that's a long winded explanation in this scenario of the pro rata rule and some things to think about. Now I'm gonna move on to the second part of this question where it says, should I just pay estimated taxes to the IRS at the time of the conversion for the converted amount?
• 10:11
  And does it make sense to do a conversion in December so the tax can be paid during next tax year's filing season instead of estimating it? So this is where things get a little bit confusing, especially in retirement and especially around Roth conversions, because here is the deal. Whenever you do a Roth conversion, that Roth conversion's income that's gonna be showing up on your $10.99, that is assumed to have been earned throughout the year. It doesn't have a date tied to it necessarily. So even if you do it on December 20, right, right before the end of the year, you technically have owed taxes on that throughout the full year.
• 10:48
  Okay? So just think of it as kinda like it averages across every day across the whole year, and you earned income every day even though you know you only earned it on December 20. So that's the problem number one, is your income is assumed to have been earned throughout the year. The second thing to know here is that whenever you're making estimated tax payments, you can't normally just make it at the time of receiving the income. Technically, your estimated tax payments are, again, assumed to have been needed to be made throughout the year.
• 11:18
  So if you know you're doing a Roth conversion in December, you're supposed to, anyway, be making estimated tax payments throughout the beginning in quarter number '1. So that's a couple things. So whenever you're asking around about, Can I do a conversion in December, just pay taxes at the end of the year, or like during tax season? And the answer is you can, but you could have some what's called underpayment penalties that are applied for being late on what you should have paid throughout the year starting back at the beginning of the year. So that's something to be aware of.
• 11:51
  Now, there's a couple ways that you can remedy this issue. The first way is you can file Form two thousand two ten, so IRS Form 2,210. It's an underpayment of estimated tax by individuals in estates and trust form, and then specifically within Schedule A of that, I would probably get help from a tax professional on this because it does this is really in the weeds and confusing for most people, and so basically what this does is is you can use what's called the annualized income installment method, and this is where you can basically say, I'm going to pay an estimated tax payment in the quarter in which I receive the income. So let's say, for example, you are get paid one time a year because you're a commission based person, and so you get you work all year and you get paid one time a year, which is hypothetical here. You don't get paid until Q3 of any particular year, and so you don't have any cash or money to pay your quarterly taxes with every year in quarter one or quarter two.
• 12:46
  And so it's like, how can I pay my estimated tax payments if I don't have any money to pay the taxes with? And so in quarter three, whenever you receive your check-in this scenario, you could also pay your estimated taxes all in quarter three. You would then have to file this form two thousand two ten for this to use this annualized income installment method and choose which quarter the taxes or your estimated payment should be applying because that's when your income was earned. So that's one solution. Again, I'd probably bring in a tax professional to help you with that.
• 13:17
  The other solution is this. Whenever you do a withholding from an IRA or a distribution out of an IRA, that withholding, that tax withholding that is then sent to the IRS, again, is assumed to have been withheld throughout the whole year, so assumed to have paid taxes on time. So if you do a Roth conversion of $50,000 and you want to withhold taxes on that $50,000 out of the conversion itself, number one, I'm not going to get into whether or not that's good or bad or a good thing for you long term or what the breakeven is on the payback on that, and so that's not the point of it, but the point of bringing this up is saying if you withhold taxes from that conversion, you do not owe any estimated tax payments because of the taxes being withheld are assumed to have been withheld throughout the full year, just like the income portion of that conversion is also assumed to have been earned throughout the full year, so you're covered. Now, here's how you could use this. Let's say you're doing a Roth conversion, you do it in November or December of the year, and then you find out about this estimated tax payment thing, you're like, man, I don't feel like figuring out form two thousand two ten, I don't know who to ask about this, I feel like I'm gonna get messed up here on these underpayment penalties.
• 14:26
  What you could do is you could make a distribution from your traditional IRA and withhold 100% of the distribution to make your tax payment. Okay? You don't have to do this extra tax form. You don't have to go through all the complexities of it. If you've done a $50,000 Roth conversion November of any particular year, or December, whatever, and then you're like, I don't think I've paid enough taxes, and I'm going get penalized here, you can simply make a distribution from your traditional IRA, have 100% of withheld to the federal government in corresponding state, if that does apply to you.
• 14:59
  That would be your estimated tax payment because what that does, again, if you withhold taxes from an IRA distribution, the tax withholdings are assumed to have been paid across the whole year. So you're covering yourself there. So a few things to think about. Obviously, number one, that's one way to do it. The most optimal way to pay tax on a Roth conversion is to make estimated tax payments and do it with cash in the bank as opposed to doing it out of a traditional IRA and withholding taxes, because now if you make that distribution, technically, that goes on your AGI even though you are withholding all the taxes, so it could change a few different things in your plan, but that's a couple different solutions to the issue of not withholding enough taxes or not paying estimated taxes on a Roth conversion.
• 15:43
  You can't necessarily get away with doing it late in the year and then just paying your taxes later because the income from the conversion is assumed to have been earned dating back to January 1 of the year, even though it technically didn't happen until later in the year. So, that's definitely complicated. I hope it helps. I hope it gives you at least something to think about and gives you some clarity and at least in some part around this. But hopefully, if nothing else, gives you what you should be looking for and analyzing further because, again, this stuff is somewhat complicated.
• 16:12
  There are penalties that could be involved here. I just would recommend either talking with your financial adviser or talking with your tax professional to help figure this out and, figure it out for this year, and that way you know what to do moving forward year after year so this stuff doesn't catch you off guard anymore. Alright. Goran, thank you so much for your questions. They're wonderful.
• 16:32
  I hope everyone else listening can glean some information or ideas from this and apply them to your situation so that you can plan smarter and retire better. Thanks so much for tuning into this week's Friday q and a. We will talk to you again next week. Hey. It's Jacob again, and I wanted to remind you that nothing discussed in today's episode is meant to be financial, legal, or tax advice.
• 16:52
  Retirement Answers is for educational purposes only. Thanks for tuning into this week's episode. I look forward to talking with you again next week.