How to Pay Taxes on Your Roth IRA Conversion

Welcome back to the channel. I hope this turned out to be some really good information for you today. I want to cover kind of the subject of how to pay for Roth IRA IRA conversion taxes. Some of the options and strategies that you can use to get that done. We get this question a lot from our clients are asking, gosh, well how am I going to pay the taxes on it? Where do I need to take it from, when do I need to do it? So I'm going to try to give you an overview on that. Full disclosure on the front end. I am not a cpa. I do not do tax preparation. But I'm going to share with you the things that we've learned from our clients CPAs and from just general knowledge. Anyway, so whatever I tell you, you might want to double check with your CPA or tax preparer as you go along through this. But I want to give you some good introduction to the subject and kind of maybe take a little bit of the pressure off and give you an idea of what you need to be taken care of. So we're going to talk just really briefly about the whole Roth IRA conversion and what the tax implications are and highlighting that really big key question of how do you effectively pay for the taxes that are triggered when you do a large Roth conversion? First of all, let's understand what the tax implication is. Right? When you do a Roth conversion, you're taking money from your IRA to a Roth IRA and that creates taxable income and it adds to your taxable income for the year which that you make the conversion. You need to be really careful if you have an IRA that has pre tax contributions and post tax contributions because they're going to affect the taxable portion. There's something called the pro rata rule that you want to look into. I'm not going to go into the details of it here, but it is pretty simple. But you just need to be aware of it if you have post tax contributions that you put into that. All right, so what are the options for paying for the taxes? A lot of people think that if they don't have any money outside of their ira, they cannot do conversions because they're concerned about paying the taxes from within the ira. And I get that that is a reasonable concern. But most people use cash or other investments that are outside of their IRA accounts. The benefit of this obviously is that it maximizes the amount that you're actually able to get converted to the Roth ira, which gives you more tax free growth inside of that. It does require that you have liquidity outside retirement accounts, meaning you have money you can actually get to. So I'm talking about saving account, maybe selling some of your other investments or reallocating funds from different places. A lot of people kind of get hung up on selling investments that have a gain in them. If you've had those investments for quite a while and you've got a long term capital gain, the highest rate of tax that you can pay on those is 20%. And I've done other videos talking about taxation and capital gains and how it factors into it that maybe you can kind of check out on the channel. But the most important thing for you to know is that if you have to go sell a stock that's highly appreciated in order to pay the taxes, that taxable income does not get added to your normal taxable income and determine a tax bracket that you got to pay taxes on for everything. The capital gains is kind of siloed inside of its own thing. You're going to look at taxable income from doing your conversions and all your other income and that's going to determine the rate of tax that you pay of capital gains. The highest amount you can pay in capital gains tax today is 20%. So I'd rather pay 20% on an outside investment that may create some tax problems for me later than pay full income tax to take it out of the IRA if I can avoid it. But it works both ways. Even if you have to take taxes from the IRA to cover it, you just have to withhold the taxes from the conversion itself. It simplifies payment without dipping into separate, separate accounts. The drawback of course is it reduces the total amount confer. I'm sorry, converted, which kind of puts a limitation on the growth potential of the IRA a little bit. But look, we got a lot of our clients who. This is all that they have. It's all the money they have. They is in that 401k they roll over to an Iraq. And so in order to get the conversion done, they have to take it out of there. And trust me, they still save millions of dollars of taxes over their lifetime and for their kids by doing it this way. It's better to do it with outside money, but if you don't have it, don't worry about it. It'll probably work out. The only a couple of instances where it doesn't work out great is if you're, if you're going to be taking oh, 4 or 5, 6% a year out of your IRA and you're doing that immediately and trying to do conversions and pay taxes. And you just really need to do the calculations to make sure that you're not going to kind of drain the account too quickly. But again, a lot of our clients do that very successfully. You just need to run the math and see kind of how that's going to affect you as well. Another situation is that if you're under age 59 and a half, you really don't want to do that. You don't, you don't want to pay taxes from the IRA because you've got penalty considerations. If you do the conversions under 59 and a half, you get that 10% penalty. You got to pay tax on it, all those kinds of things. So for our clients that are under 59 and a half, we try to get creative with, are there other assets you can use? Can you stop making some of the contribution to your 401k and redirect some of that discretionary income over to pay taxes? A lot of different opportunities there. If you're under 59 and a half, you got to be a little bit careful of how you do it. But again, it still works out great, especially if you're that IRA millionaire that we really try to reach and educate and talk to. This is really going to be worth it to you. If you have a more modest 401k balance, then the, the problems down the road are not going to be as big. And so your conversion strategy is, probably needs to be handled differently. But the tax implications are the same. And a lot of what I'm saying to you today is still relevant if you have that more modest IRA balance. Okay, so where we are then is you've decided you're going to do a Roth conversion. You, you're going to make, you're going to do the conversion, it's going to create a taxable event, and now you got to pay the tax. So here's a little bit of a breakdown of when the taxes are due for that Roth IRA conversion and how the quarterly payments get calculated and when penalties might apply to you. Again, I'm not a cpa. I'm just kind of giving you educational information here. I've got to cover my rear end so that you understand that this is not CPA level information, although I think it's pretty relevant and pretty accurate. There are things in your own circumstances that can change this that you need to be aware of. And that's where you really need to seek the guidance of a professional. And We've got several CPAs around the country that we work with, and we'd be happy to introduce you with somebody there, too. So, first of all, when are the taxes due? Well, first of all, taxes owed on a Roth conversion are really due by the regular tax filing deadline for the year in which you do the conversion, and that's typically April 15th of the following year. However, if the conversion significantly increases your taxable income, paying taxes throughout the year can prevent some penalties to you. So there is an option to pay with quarterly estimated taxes. Right. So if the tax from a conversion causes an underpayment of taxes based on different income tax thresholds that exist, you may need to be paying taxes quarterly to avoid the penalties. Even if you get all of the tax paid, if you don't do it in the right timing, you could actually see a penalty for getting that done. And you're going to use IRS Form 1040 ES, I think it is. It's where it allows you to calculate the quarterly payments based on what you, what your projected annual tax liability is, including the conversion amount that you're going to take from the ira. And generally speaking, as you probably already know this, you know the, those estimated payments are due normally April 15, June 15, September 15, and then January 15 of the following year for your fourth quarter estimated payment. Now, there is what's called a safe harbor rule. And so in order to avoid penalties, you want to make sure that you pay at least 90% of your total tax liability for the current year or 100% of your prior year's tax liability. But more likely, if you're going to be doing conversions, you probably are going to fall into the high income taxpayer category. And so you're going to want to make sure that you get paid in 110% of your prior year tax liability to make sure that you avoid penalties. So when, when do penalties apply? Well, easily. I mean, it's, most people already know this, but I'll say it. If you, if you, if you don't pay enough tax during the year, the IRS may impose an underpayment penalty. And this can apply, like I've already said, even if you pay the full amount by the filing deadline. If your estimated payments or your withholding are insufficient throughout the year to cover it, you can get some penalties. All right, so let's transition just a little bit to a little bit different subject of what are the strategic approaches to minimize the tax impact. And I talk about this. I've written two books about it. We do webinars every month about it. I've done a multitude of YouTube videos you can see, we've done podcasts on it. I mean there's, I've done a tremendous amount of research on this. We've got 14 years at this point of specializing in this particular area. And we've learned a lot. You know, if you go in and you go to Google or Chad GPT and you ask them what's the right approach, they're going to tell you to develop a plan that only goes to the top of your current tax bracket. And I'll just tell you that that that simple way of doing Roth conversions if you're an IRA millionaire is a really bad idea. And you're going to leave a ton of money on the doorstep of the IRS by doing it that way. You want to go take the effort and the time and perhaps the expense to develop a strategic plan that evaluates every tax bracket way above where you're currently at even and even lump sum amounts that maybe would be based on your situation because of work or because of inheritances or because of selling a business or all whatever the situations can be. It needs to be a very unique, very customized, very personalized game plan if you really want to maximize all the benefits. And that's, I mean, let's just keep in mind what we're trying to do is we're trying to maximize the total taxes that you can save. And over your lifetime, we want to maximize your tax adjusted net worth over your lifetime. Your tax adjusted net worth is how much is really my money of everything I have. And if you you sitting with $2 million in an IRA when you're 85 years old, it's not all your money you're having to pay. RMDs on it. Plus it's not really comparing apples to apples. So the goal is to maximize what your tax adjusted net worth is, money you actually can get your hands on without a tax on an after tax basis. And then the third objective of doing all these conversions is to maximize the amount that's available for your heirs. One of the other little tricks that you can use, if you're somebody that you're already giving to your favorite charities and you give significantly, I'm not going to put a number on that. But if you're giving $1,000 a year, this isn't really a good strategy for you. If you're giving 20, 30, 40, 50 or more thousand a year to charities, then there's something called donor advised funds. There are different kinds of trusts you can set up. The donor advised fund is my favorite because it's really simple. It's easy to do it. Almost any custodian where you already have your money at and what that allows you to do is kind of aggregate a lump sum of a huge contribution that you're going to be that you would have made anyway. But do it all up in, let's say one year, for example. You could, it can happen over multiple years, but let's say you did it over one year. You had money that you put into that donor advised fund. Now it is going to serve as a charitable gift for this year and then you get a checkbook and you can then dole that out over your lifetime however you want to to whatever charities you were going to give it to. But the benefit of that is you could take just for example, a large $200,000 donor advised fund donation and you could offset $200,000 of your conversion this year. So if you know you're going to be making contributions to a charity and you have the assets, then developing a game plan that combines all these things can really reduce your tax burden very tremendously and give some real big benefits. You know, most of the time we split our conversions over somewhere between four to 10 years is where they just tend to land. That's not anything that we put parameters on. It's just as we go through the math, most of our clients that we work with, their game plan is between four and 10 years. We have a few that we just rip the mandate off and we get it done over a year or two. But most people, it takes a little bit longer. And there probably is another video uploaded by now where I talk about the benefits of doing it all at once or doing it over a period of years. And I list some of the caveats in that, that probably you can find a thumbnail someplace on this page or on our channel and do that. And by the way, you know, if, if you like this kind of stuff, hit the like button. I've got a little bit more to say to you, but it occurred to me, hit the like button. Subscribe to the channel. So it's your first note. When we come out with new stuff. I do believe that in, you know, there we. We have a lot of clients that are very astute financially. They're good at math, they're good at spreadsheets, but they come to us anyway because they want a level of insurance that they really have found the right game plan. And so whether it's us or somebody else, get a professional that really understands this. And it may not be the financial advisor or the CPA that you have now. We have found over the years that CPAs have a really hard time getting their head around accelerating these. My own CPA has a difficult time with it, but she read the book and now she's kind of a believer in what we do. And it takes them getting educated a little bit. But there are a lot of moving pieces in this and it just seems to me on something that really could save you a couple million dollars of income taxes, it's probably worth investing in getting some professional help to make sure that you get all of the water out of that wash attic that you're trying to squeeze. A lot of. The tax simulation software that I've seen online is it, it's in one or two camps. The 90% of it has built in assumptions that you only convert to the top of your tax bracket. And so if you've got a lot of money and you have a good income, it's probably going to tell you it's not worth it to do it or it's going to have you converting over 25 years. And what they won't tell you with that is because they haven't even thought about it is doing it that way you're going to actually pay more tax than if you just skip the exercise altogether. The other camp on the software can give you, you can get to the right answer, but you it's not presented in a way where you can actually really evaluate how did this affect my net worth? How did it affect my total taxes? I mean the answers are there but it's just all over the place. And then of course, you know, when I first started this, I started with using Excel spreadsheets and it was okay for a short period of time. And then I realized it left a lot to potential error cells that didn't get done, formulas that didn't transfer over. And more importantly, it just was so time consuming to really do a good job and evaluate every tax bracket and shades in between. And so as you probably know from watching a lot of our stuff, we had proprietary software written that allowed that makes that a much easier and a much more user friendly experience. So in conclusion, develop a strategic plan, know the tax savings and the tax cost going into that plan, execute before year end or throughout the year and then be sure to prepare for and take care of your tax responsibilities. And if you do all those things, you should have a lot more clarity around what you, what you should do and what the right information is and what you're doing, why you're really doing this, what the benefits are. And when you have that clarity, you have the confidence then to move forward. And it gives you a lot of peace of mind that knowing that you really have done the absolute best thing that you possibly can. So I hope this has been helpful again. Like it subscribe to the channel and we'd love to help if we can take care of.