Tax planning and compliance for investors
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Kaye A. Thomas
Updated January 21, 2008
Determining how much tax you'll pay if you convert a traditional IRA to a Roth IRA.
No one should make a Roth IRA conversion without having some idea how much tax the conversion will cost. Here are some guidelines for estimating the tax cost of your conversion.
When calculating the tax cost of converting an IRA, remember that it isn't a fixed number. You can manage the tax cost of your conversion by reducing the size of your conversion. You don't have to convert your entire IRA. See Partial Conversions.
The tax cost of a conversion is determined mainly by your tax bracket. You have to be aware, though, that the conversion itself can move you into a higher tax bracket. You need to know two things: what your tax bracket is, and how much additional income you can report before you move up into the next tax bracket.
Some people worry that if they move into a higher tax bracket, all of their income will be taxed at a higher rate. That's not the case. Only the part of your income that falls in the higher bracket gets taxed at the higher rate. If you are otherwise in the 15% bracket and have $1,000 of income that's in the 25% bracket, you'll pay $250 of tax on that extra $1,000 but still pay lower rates on the rest of your income. For more on this topic, see Your Tax Bracket.
Instead of looking at your tax bracket and using percentages, an easier way for many people to estimate the tax cost of a conversion is to pull out the previous year's tax return and figure out how much higher the tax would be if the conversion income is added to taxable income. For example, if the conversion income is $15,000 in 2008, pull out your 2007 tax return and add $15,000 to your taxable income. Then look up the new taxable income amount in the tax tables to see how much higher the tax is. Of course this method isn't accurate if your filing status has changed or if your income or deductions are significantly different in 2008. As explained below, it isn't always accurate even when these factors aren't present.
There are problems with the simplified method described above. It doesn't take into account various ways the conversion income might affect your tax return. For example, this added income might cause you to lose part of your dependent care credit, or part of your exemptions. Furthermore, the simplified method doesn't take into account any differences in your income or deductions.
To get a more accurate estimate of the actual tax cost of the conversion, a tax pro might take your prior year return and redo it, plugging in not only the added income from the conversion but also estimated adjustments for other significant changes. Normally it isn't necessary to go through all the same detailed work you would do in preparing an actual return, but it can be helpful to work through the return, rather than just tack a number onto your taxable income. That way, unpleasant surprises are less likely.
If you used software to prepare your return last year, you may be able to get a pretty accurate estimate fairly easily. Just fire up the software and plug in additional income representing the conversion. Using tax software often makes it much easier to play "what-if."
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