Understanding Withholding Taxes on Roth IRA Conversions

Hey, this is Craig. Welcome back to the channel. So today we're going to kind of COVID one of those kind of boring but really important subjects of strategies for handling income tax withholding and tax payments while you're doing Roth conversions. So, as you know by now, we work with a lot of different people, a lot of different income ranges, a lot of different varying sizes of Roth conversions each year. And we've learned a lot, and we've spoken to their CPAs, and we've learned from tax people of what the right strategies are. And I will say on the front end, if you have a tax preparer or a tax professional that you work with, you want to talk to them first about how they feel like you should do that. What I'm going to give you today is really just educational content and things that we've learned over the time of doing it. But we're not CPAs, and we don't sign tax returns, and we're certainly not paid by you to do your tax return. So that's the person that you probably want to go to to find out what's actually best for you. But generally speaking, part of what we want to do is to understand that you do have a tax liability when you do a Roth conversion, and that taxable amount of that is generally it is the amount of the conversion. So if you do $100,000 Roth conversion, that's an additional $100,000 of taxable income, and that could cause you to actually go to a higher tax bracket for some or all of that that you need to be aware of. I wouldn't let that scare you away. We've learned over time that if you're really a good candidate for Roth conversions, you're better off to get to a higher tax bracket. It's kind of like pulling the band aid off tends to work. Now, you can't pull it off too fast or it's a little bit too painful and you don't want to do it too slow, or you probably didn't have any real benefit of doing the Roth conversions in the first place. So you got to calculate what your taxable amount is, and that's really just determined by the amount of your IRA that's going to be converted, and that's added to your taxable income for the year. Then you got to estimate the tax liability. So you take your current tax bracket, figure out how much of that income of that. Let's say that's the $100,000 conversion you did, how much of that is at your current tax bracket. So let's say you convert 100,000 and you know that 50 of that is at 24% bracket. Well, 50,000 times 24% is, what is it, about $12,000. You have the other 50,000 that's at the higher tax bracket. And so you add those two taxes together and that's what you owe from doing the conversion. So you have to figure out how you're going to handle that. You could certainly adjust if you know what you're going to be doing. You could adjust your withholding from your other income sources to take care of it. But normally the most practical way to do it is just to make estimated tax payments or have a specific withholding amount as you do each of the conversions. But you want to make sure that you make that you get the taxes paid. The easiest thing to do is, as I've said, is just make quarterly tax payments. You could adjust your withholding, but making those tax payments on the quarter dates of April 15, June 15, September 15, January 15, and make sure you get enough paid in so you don't have penalties. You don't want to underpay the tax. They certainly will allow you to overpay it, but you don't want to underpay it. If you underpay it. There's a potential for having a penalty for underpayment. But the IRS has what are called safe harbor rules. Paying 100% of this current year's tax liability will work as long as you know what that is. So as long as you get enough paid in, you're good. There's. But the safe harbor rules tell you say that if you, if your adjustable gross income is over 150,000, you need to pay 110% in of what your total tax liability would be to help avoid underpayment. So just make sure that you withhold the right amount that you make your estimated payments. Right. Alternatively, if, if your payments cover at least 90% of your current year's estimated tax liability, that's another way to kind of avoid that. And they're a little bit complicated. I would say go into the IRS and just kind of search for safe harbor rules because part of it has to do with your adjusted gross income and how much income you got coming in, all those kinds of things. Now let me get to more of a strategy thing where a lot of people, a lot of advisors and a lot of tax people tell you to do is to spread those conversions out over a long period of time. So instead of just converting massive amounts over a short period of time. They want you to do it over a long, long period of time. And if you have a lower balance in your IRA and your resulting income needs are also going to be pretty are also part of that, then you probably don't need to worry about this. In fact, Roth conversions may not even be a benefit to you. But if you have a larger IRA balance, 7, $800,000 up into the millions, and whether your income is low or high, you're probably a great candidate to do accelerated Roth conversions. And so you want to really make sure that you get the taxes paid. And the easiest thing to do is just if you do a conversion and let's say it happens to be during the middle of a quarter, then just make sure that when that next estimated tax, tax payment date happens, that you cut a check or we, we just use the electronic transfers now to make all that stuff work. If you happen to be withdrawing money from other tax deferred accounts, other IRAs, then just maybe adjust your withholding when you're from that account while you're doing the distributions from maybe a different one. Let's say you have two different accounts and you're converting one and the other one is just providing income. Maybe you just adjust your withholding from the second one. But there are a lot of ways to do can be complicated. I know our CFPs work with people every day to help them come up with the right strategy. Certainly you would want to consult with whatever tax professional that you're using. It can be complicated and especially when you go from maybe just retired and low income to all of a sudden adding two or $300,000 of Roth conversion income into your life. You want to make sure that you don't get tagged for underpayment of penalties. Once you have a strategy in place, then you probably have got a system that you can use while you're getting the conversions taken care of. But I think it's very well worth having a CPA involved, especially in the first few years, until you really feel confident with it. If you, if they're worth their weight and salt, they probably will save you in tax more than you end up paying them to prepare the returns. But I know some of you are consummate do it yourselfers and you don't want to pay somebody else to do it, but they come along. But there, there are a few instances in life where probably is a good idea to pay somebody to get some advice on something just to make sure that you don't stub your toe on it. So hopefully that covers just kind of the basics of it, nothing earth shattering other than me to make sure that you know that you do have a taxable event, and you do want to make sure that you get your taxes paid, and that there are safe harbor rules that allow you to make sure that you don't get a penalty for underpayment. So hopefully that was a little bit of help to you. If you like this kind of content and you want to make sure you get more little tidbits, subscribe the channel like it and share it if you found it of any kind of value at all. We have other videos that go into more detail on covering the subject. This one was really just intended as kind of a broad overview to remind you that this is something that you really need to pay attention to and get it done right. Okay, Hope that helps.