Estimated taxes, something most working Americans don't have to deal with or may not even be aware of, can be a hidden cost when converting traditional IRAs to Roth IRAs.
With proper planning, however, this potential trap can be easily avoided.
Estimated taxes are payments we must make four times a year to the Internet Revenue Service if the amount we have withheld for taxes at work or elsewhere does not meet certain minimums.
If we fail to make the required estimated payments -- due
This is not a problem for most American workers, who instead tend to have too much money withheld from their paychecks and get large refunds.
But the income from a large Roth IRA conversion is likely to create a tax liability that may trigger the need to increase withholding and/or pay estimated taxes.
From the year 2011 on, income from a conversion must be reported for the year the conversion is made. But for conversions made in 2010, taxpayers can either report the entire conversion income for 2010, or report half of it for 2011 and the other half for 2012. This latter income split is the "default" option, or what will happen if the taxpayer does not choose otherwise.
The decision of when to report the income is not made until the taxpayer files the 2010 tax return in 2011. Therefore, somebody choosing to report the Roth IRA conversion income for 2010 may discover after the fact that he owes a penalty for not having enough withholding and/or not paying enough estimated taxes in 2010.
But we can avoid a penalty by using any of three so-called "safe harbor" methods.
The easiest to implement -- it's foolproof and you don't have to make any estimates -- is to have your withholding and any estimated tax payments add up to 100 percent of your total tax liability for the previous year, or 110 percent if your adjusted gross income was higher than
For example, my wife, Georgina, and I, filing jointly, had income of less than
And under this safe-harbor method, we would then have to increase our estimated tax payments in 2011 to reflect the higher tax liability for 2010.
We have other options, though. A second "safe harbor" method is to have withholding and/or estimated taxes add up to at least 90 percent of the current year's total tax liability. This method would lower estimated payments for 2011, but at the risk of estimating wrong and owing a penalty. A third safe harbor is that no penalties are due if your total tax due when you file your return is less than
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Personal Finance - Avoid Tax Trap When Converting Traditional IRA to Roth IRA
(c) 2010 Humberto Cruz,