A reader reminds me of a potential pitfall of individual retirement account conversions.
I've read a few articles, including yours, about the benefits of converting a traditional IRA to a Roth IRA. I did this last year (converted just enough to stay in the 15 percent tax bracket), but now it seems I'll be paying a penalty because of not making estimated tax payments. None of the articles I've read about IRA conversions mentioned making estimated tax payments to avoid a penalty. This is an important point.
I plead guilty to this oversight, as should other writers. Just like you, I don't recall seeing any articles about this issue.
Allow me to do one, starting with some basic explanations.
A traditional IRA lets your money grow tax-deferred until withdrawn. Based on eligibility rules (they are a bit too complex to get into here), you may receive a full or partial tax deduction on your contributions. When you take the money out, you will owe ordinary income taxes on the previously untaxed money, including all account earnings.
A Roth IRA doesn't give you a tax deduction on your contributions. But once you turn 59 1/2 and have had the Roth IRA at least five years, withdrawals are tax-free. Unlike traditional IRAs, Roth IRAs are not subject to required minimum distributions after age 70.
For these reasons, many financial advisers recommend that people who have a traditional IRA and are currently in a low tax bracket consider converting all or a portion of it to a Roth IRA. To be eligible, your modified adjusted gross income on any year you convert, not counting the amount converted or IRA required minimum distributions, cannot exceed $100,000.
When you convert, you owe taxes on the amount converted as if you had withdrawn it from the traditional IRA - which in effect you have - but without the 10 percent penalty normally imposed on withdrawals before age 59 1/2 .
Basically, what you're doing when you convert is deciding to pay taxes now so you won't have to pay them in the future, presumably when the converted IRA will have grown to a much bigger amount. Conversion makes the most sense if you can pay the taxes due without exceeding your current tax bracket - in your case, 15 percent - and if you expect to be in a higher tax bracket in the future.
But what about the problem of estimated taxes?
According to our tax laws, it's not enough that we pay whatever we owe every April 15. We must pay our taxes as we go throughout the year.
When you have taxes withheld from a paycheck, the withholdings take care of this requirement, provided you don't owe too much at the end. For detailed rules and useful advice, get Publication 505, Tax Withholding and Estimated Tax and Publication 919, How Do I Adjust My Tax Withholding? from the Internal Revenue Service at 800-829-3676 (or www.irs.gov).
If you don't withhold enough or don't have money withheld at all - if you're retired receiving investment income or are self-employed like me, for instance - you must make estimated tax payments four times during the tax year: by April 15, June 15, Sept. 15 and Jan. 15.
When you convert a traditional IRA to a Roth, the additional taxable income from the conversion may require you to make estimated tax payments. (One exception would be if you have taxes withheld at work and the withholding is already high enough or can be increased to take care of this new tax liability.) Otherwise, failure to make the minimum required estimated payments could trigger a penalty, even if you pay the full amount due by April 15.
What this means in essence is that taxpayers subject to estimated payments - nearly 10 million, including me - must figure out their taxes not once but four times a year. About two-thirds pay too much or too little.
Humberto Cruz is a columnist for Tribune Media Services.