using inherited IRA to pay tax on Roth conversion?

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Topic Author
sgoak
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Joined: Sun Aug 14, 2022 10:05 am

using inherited IRA to pay tax on Roth conversion?

Post by sgoak »

Hello,

I am considering doing conversions from a rollover traditional IRA to a Roth IRA.

It seems the general recommendation is to use after-tax funds to pay the ordinary income tax due
on the conversion. (This in effect uses after tax money to increase the amount in the Roth IRA compared
to using the traditional IRA for taxes.)

My question is, what are the downsides of using an inherited IRA (10 year distribution requirement)
for the taxes due? (Assumption 1 is that funds will not be needed for 20 years, then will be withdrawn. Assumption 2 is that the extra withdrawal now from an inherited IRA will not change current tax bracket.)

Option 1 (general recommendation)
If tax is paid using after-tax funds now, in 20 years the inherited IRA funds will
be taxed twice: first at the ordinary income tax rate, and second for any capital gains in the 10+ years
after the distribution.

Option 2 (alternative)
If tax is paid using the inherited IRA funds now, the after-tax funds will have capital gains tax due in 20 years.

There can be a lot of different assumptions of growth and taxes, but a simple spread sheet calculation using current ordinary income and cap gain rates showed similar results using either after-tax or inherited IRA funds for paying the tax on conversion. I can add this calculation if it is helpful.

Thanks in advance for your insights.
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retiredjg
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Re: using inherited IRA to pay tax on Roth conversion?

Post by retiredjg »

Welcome to the forum. :happy

When doing Roth conversions, it is preferable to use "other" money to pay the tax and for the reason you mention - more money gets into Roth IRA. Also, if you are under 59.5, there is no penalty to pay for early withdrawal of the IRA money used to pay the taxes.

In this case, you can use the inherited IRA money to pay the taxes with no penalty even if you are under 59.5 because it is not an early withdrawal.

The only con for using the inherited IRA, that I can see, is that it adds to income which might reduce the amount you can convert if you are trying to stay under a certain number.

Other than that, I don't think it matters much where the money comes from. If there is any long term difference, it would not be significant enough to matter.
ralph124cf
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Re: using inherited IRA to pay tax on Roth conversion?

Post by ralph124cf »

I'm not sure what it is exactly that you are trying to do.

Are you trying to transfer money from your inherited IRA to your Roth? I don't think that is allowed.

Are you trying to transfer money from your inherited IRA to an inherited Roth? I don't think that is allowed either.

Are you planning to transfer some of your own IRA to your own Roth, while simply using the inherited IRA money to pay the tax? That is fine. Remember, money is fungible. You are required to take money out of the inherited IRA, and pay taxes on it. The money doesn't know where it came from. You can choose to use that money to pay a Roth conversion tax, or take a Hawaiian vacation.

The comments about not using converted money to pay the taxes referred to withdrawing enough of YOUR IRA money to both do the conversion and pay the tax, because If you wanted to convert $70,000 of your IRA, and did not have enough money to pay the extra tax, then you would have to with draw $100,000 from your IRA in order to pay the tax of $30,000.

Ralph
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arcticpineapplecorp.
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Re: using inherited IRA to pay tax on Roth conversion?

Post by arcticpineapplecorp. »

can you tell us a little more like :

Do you already max out your tax advantaged accounts each year?
What age are you (i.e., are you in retirement already, close to retirement, far away from retirement etc)
Is it possible you'd be in a lower tax bracket during the next 10 years when withdrawals from inherited IRA might be more favorable than now?

that sort of thing.

yes, i think seeing your calculations would also be helpful.

welcome to the forum.
It's hard to accept the truth when the lies were exactly what you wanted to hear. Investing is simple, but not easy. Buy, hold & rebalance low cost index funds & manage taxable events. Asking Portfolio Questions | Wiki
vtMaps
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Re: using inherited IRA to pay tax on Roth conversion?

Post by vtMaps »

We do Roth conversions. We have no taxes withheld (fed or state) from any source of income or from the Roth conversions.
In December each year I figure out what our taxes will be, and then take a distribution from an inherited IRA to pay the taxes. I have 100% of the distribution withheld for taxes. Much easier than dealing with estimated taxes.

The distribution itself is taxable income, so I have to plan for that when I take the distribution.

--vtMaps
"Truly, whoever can make you believe absurdities can make you commit atrocities" --Voltaire, as translated by Norman Lewis Torrey
curmudgeon
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Re: using inherited IRA to pay tax on Roth conversion?

Post by curmudgeon »

Using withdrawals from an inherited IRA can be a convenient way to pay taxes on Roth conversion of your personal IRA. It's not a big deal, but it has a few small advantages. It needs to be planned in the context of your overall taxable income and tax brackets, as the withdrawals will count as additional ordinary income.

Probably the most convenient factor is that withholding done in the inherited IRA withdrawal counts as if it was paid evenly throughout the year, regardless of when it was actually done, and so it can remove the need to make quarterly estimated tax payments (I've run into the case where the online form only allowed me to designate 99% as the withholding for tax, not 100%, but that's a minor nit).
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FiveK
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Re: using inherited IRA to pay tax on Roth conversion?

Post by FiveK »

sgoak wrote: Sun Aug 14, 2022 11:12 am My question is, what are the downsides of using an inherited IRA (10 year distribution requirement) for the taxes due?
Possibly none, especially if you would choose to take those distributions every year in any case, perhaps to avoid a high marginal tax rate bite that would occur if you waited until the 10th year to withdraw all.

If taking the inherited distribution anyway, once you take it there is no difference between that money and what you already had in a bank account, so using it toward the conversion tax is paying the tax from "cash on hand".

Whether to do a Roth IRA conversion at all is a related but different question. Assuming that appears favorable, yes, using the cash flow from the inherited IRA for taxes makes sense.
Marylander1
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Re: using inherited IRA to pay tax on Roth conversion?

Post by Marylander1 »

I used an inherited IRA to pay Roth conversion taxes when a sudden health catastrophe severed my income, but provided a good opportunity for lower Roth conversion tax rates. It seems a wise plan to me.
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retiredjg
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Re: using inherited IRA to pay tax on Roth conversion?

Post by retiredjg »

I think what vtMAPS and curmudgeon are doing - doing a withdrawal from inherited IRA and withholding the tax from that - is a bit brilliant...because it avoids the hassle if estimated taxes.
Topic Author
sgoak
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Re: using inherited IRA to pay tax on Roth conversion?

Post by sgoak »

arcticpineapplecorp. wrote: Sun Aug 14, 2022 12:49 pm can you tell us a little more like :

Do you already max out your tax advantaged accounts each year?
What age are you (i.e., are you in retirement already, close to retirement, far away from retirement etc)
Is it possible you'd be in a lower tax bracket during the next 10 years when withdrawals from inherited IRA might be more favorable than now?

that sort of thing.
I'm in early 60s, retired with pension, expecting income to increase after starting social security so doing
some conversions now.
arcticpineapplecorp. wrote: Sun Aug 14, 2022 12:49 pm yes, i think seeing your calculations would also be helpful.
I tried to simplify things as I don't know what tax brackets will be in 20 years, or what market growth will be.
So I assumed I had the same ETF in each type of account, and the ETF pays no dividends to be reinvested.
To make the arithmetic easy, I assumed ordinary income tax as 1/3, and capital gains tax as 1/4.
I also assumed that there is a lot of growth over the next 10-20 years, so that the ETF in the after-tax
account will owe capital gains of 1/4 on the balance.

I assume that the ETF shares will be used to pay tax. Before the end of 10 years, the inherited IRA must be distributed.

Initially I assume after-tax: 40 sh, Inherited IRA: 60 sh, Traditional IRA: 120 sh, Roth: 0 sh

If using after-tax to pay tax on conversion (40 sh = 1/3 120 sh),
then at year 1 I have: after-tax 0 sh, Inherited IRA 60 sh, Trad IRA 0 sh, and Roth 120 sh.
At year 10 or before, the inherited IRA is distributed to after-tax giving 40 sh (40 sh = 60 -1/3 60 sh).
If liquidating at year 20: after-tax of 40 sh -1/4 of 40 sh = 30 sh + 120 sh Roth, so total = 150 sh to spend.

If using inherited IRA to pay tax on conversion, the tax is 1/3 on distribution of 60sh+120 sh = -60 sh.
So after conversion I have: after tax 40 sh, inherited IRA 0 sh, Trad IRA 0 sh, and Roth 120 sh.
If liquidating at year 20: after-tax of 40 sh -1/4 of 40 sh = 30 sh + 120 sh Roth, so total = 150 sh to spend.

(Sorry for all the text, probably a diagram would be more clear).

As an aside, using the traditional IRA for conversion taxes is not as good, as is well-noted.
At 20 years, after tax has 40 sh + 40 sh from inherited Roth, and Roth has 80 sh. When liquidating,
have 80 sh -1/4 80 = 60 sh + 80 sh Roth, so total of 140 sh to spend, 10 less.
arcticpineapplecorp. wrote: Sun Aug 14, 2022 12:49 pm welcome to the forum.
Thank you very much for your response and welcome.
Topic Author
sgoak
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Re: using inherited IRA to pay tax on Roth conversion?

Post by sgoak »

curmudgeon wrote: Sun Aug 14, 2022 1:04 pm Using withdrawals from an inherited IRA can be a convenient way to pay taxes on Roth conversion of your personal IRA. It's not a big deal, but it has a few small advantages. It needs to be planned in the context of your overall taxable income and tax brackets, as the withdrawals will count as additional ordinary income.

Probably the most convenient factor is that withholding done in the inherited IRA withdrawal counts as if it was paid evenly throughout the year, regardless of when it was actually done, and so it can remove the need to make quarterly estimated tax payments (I've run into the case where the online form only allowed me to designate 99% as the withholding for tax, not 100%, but that's a minor nit).
This is very helpful to know. Thank you.
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celia
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Re: using inherited IRA to pay tax on Roth conversion?

Post by celia »

ralph124cf wrote: Sun Aug 14, 2022 12:42 pm I'm not sure what it is exactly that you are trying to do.
Me neither.
The comments about not using converted money to pay the taxes referred to withdrawing enough of YOUR IRA money to both do the conversion and pay the tax, because If you wanted to convert $70,000 of your IRA, and did not have enough money to pay the extra tax, then you would have to with draw $100,000 from your IRA in order to pay the tax of $30,000.
But then you’d have to pay taxes on both the $70,000 + $30,000 withdrawals. So THAT might be another withdrawal which would also be taxed!
scrabbler1
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Re: using inherited IRA to pay tax on Roth conversion?

Post by scrabbler1 »

curmudgeon wrote: Sun Aug 14, 2022 1:04 pm Using withdrawals from an inherited IRA can be a convenient way to pay taxes on Roth conversion of your personal IRA. It's not a big deal, but it has a few small advantages. It needs to be planned in the context of your overall taxable income and tax brackets, as the withdrawals will count as additional ordinary income.

Probably the most convenient factor is that withholding done in the inherited IRA withdrawal counts as if it was paid evenly throughout the year, regardless of when it was actually done, and so it can remove the need to make quarterly estimated tax payments (I've run into the case where the online form only allowed me to designate 99% as the withholding for tax, not 100%, but that's a minor nit).
I help a friend out with his portfolio and tax management, and I use the RMD from a small inherited IRA to pay some federal and state income taxes due from the investment portion of his portfolio (which came from the same inheritance as the IRA). By doing this, he doesn't have to worry about any underwithholding or estimated taxes because, as you wrote, the 1099R withholding is treated like W2 withholding, so even if we do the RMD in mid-December, it is treated like it was done throughout the year.

Because the money is simply moving from one account to another, or to the taxing agencies, it is transparent to him and keeps his April tax bills low. I wait until the end of the year to do the RMD because by then there has been enough cash which has built up within the inherited IRA from its investments to make the RMD simple, and I have a good idea as to what the tax % allocations should be so that he either owes very little or gets a tiny refund which we roll into the following year (less than $75 in either direction).
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celia
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Re: using inherited IRA to pay tax on Roth conversion?

Post by celia »

sgoak wrote: Sun Aug 14, 2022 11:12 am My question is, what are the downsides of using an inherited IRA (10 year distribution requirement) for the taxes due? (Assumption 1 is that funds will not be needed for 20 years, then will be withdrawn. Assumption 2 is that the extra withdrawal now from an inherited IRA will not change current tax bracket.)
Assumption 1 is faulty since the Inherited IRA must be emptied within 10 years. Assumption 2 may or may not be correct dependinding on how much you withdraw in each year and what other Taxable Income you have each year. If you empty it out in one year, the amount may be enough to push you into the next bracket. In addition, tax brackets are scheduled to increase in 2026.
Option 1 (general recommendation)
If tax is paid using after-tax funds now, in 20 years the inherited IRA funds will
be taxed twice: first at the ordinary income tax rate, and second for any capital gains in the 10+ years after the distribution.
The money in the IRA will only be taxed when it is withdrawn. The separate capital gains (growth) after that will only be taxed when they are distributed by the fund (like interest) every year or when the asset is sold and it gained value while you owned it in Taxable). If you die while still owning it, the taxable account will get a step-up in cost basis and no taxes will be owed.
Option 2 (alternative)
If tax is paid using the inherited IRA funds now, the after-tax funds will have capital gains tax due in 20 years.
If “After-tax” refers to assets in the Roth IRA, there will be no further tax owed by the account owner or the heirs.

If “After-tax” refers to a Taxable account, capital gains that are part of fund distributions will be taxed for the year they are distributed. The cost basis for the shares purchased will be determined by the going price on the date the shares are bought. Capital Gains earned by fund distributions will be taxed for the year they are received and if re-invested, will usually show a higher price paid for these shares added every year. When “Capital Gains” refers to you selling the fund at a profit, then the taxes will be due on only the gains.

NOTE: There are two kinds of Capital Gains here: those earned by the fund that gets passed onto the shareholders each year and those that the shareholder gets from selling off their shares.
Last edited by celia on Sun Aug 14, 2022 6:39 pm, edited 1 time in total.
Topic Author
sgoak
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Re: using inherited IRA to pay tax on Roth conversion?

Post by sgoak »

celia wrote: Sun Aug 14, 2022 5:14 pm
ralph124cf wrote: Sun Aug 14, 2022 12:42 pm I'm not sure what it is exactly that you are trying to do.
Me neither.
The comments about not using converted money to pay the taxes referred to withdrawing enough of YOUR IRA money to both do the conversion and pay the tax, because If you wanted to convert $70,000 of your IRA, and did not have enough money to pay the extra tax, then you would have to with draw $100,000 from your IRA in order to pay the tax of $30,000.
But then you’d have to pay taxes on both the $70,000 + $30,000 withdrawals. So THAT might be another withdrawal which would also be taxed!
Thanks for your reply.

Question is basically where to get funds to pay tax on traditional IRA conversion to Roth IRA.
Can a withdrawal from an inherited IRA be used instead of withdrawing after-tax funds to pay taxes, with similar long-term results? From earlier replies, the answer appears to be yes, and may have benefits in avoiding quarterly estimated taxes.


Yes on withdrawal taxes. With a 1/3 ordinary income tax rate, one needs to withdraw $150,000 from IRA(s) and pay $50,000 tax (1/3) to end up with $100,000 in Roth.
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celia
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Re: using inherited IRA to pay tax on Roth conversion?

Post by celia »

sgoak wrote: Sun Aug 14, 2022 6:37 pm Question is basically where to get funds to pay tax on traditional IRA conversion to Roth IRA.
Can a withdrawal from an inherited IRA be used instead of withdrawing after-tax funds to pay taxes, with similar long-term results? From earlier replies, the answer appears to be yes, and may have benefits in avoiding quarterly estimated taxes.
Correct.
Yes on withdrawal taxes. With a 1/3 ordinary income tax rate, one needs to withdraw $150,000 from IRA(s) and pay $50,000 tax (1/3) to end up with $100,000 in Roth.
The simple way to look at this is that your pre-tax IRAs have a lower spending value than the account value. If you pay about 33% to the feds and state, you are going to lose 1/3 of any withdrawal before you can spend the money. You can pay the taxes from any pot of money, but if you are under 59.5, there will be a 10% early withdrawal penalty if you withdraw from YOUR OWN IRA to pay the taxes. There is no penalty on withdrawals from Inherited IRAs.
A dollar in Roth is worth more than a dollar in a taxable account. A dollar in taxable is worth more than a dollar in a tax-deferred account.
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sgoak
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Re: using inherited IRA to pay tax on Roth conversion?

Post by sgoak »

celia wrote: Sun Aug 14, 2022 6:52 pm
sgoak wrote: Sun Aug 14, 2022 6:37 pm Question is basically where to get funds to pay tax on traditional IRA conversion to Roth IRA.
Can a withdrawal from an inherited IRA be used instead of withdrawing after-tax funds to pay taxes, with similar long-term results? From earlier replies, the answer appears to be yes, and may have benefits in avoiding quarterly estimated taxes.
Correct.
Yes on withdrawal taxes. With a 1/3 ordinary income tax rate, one needs to withdraw $150,000 from IRA(s) and pay $50,000 tax (1/3) to end up with $100,000 in Roth.
The simple way to look at this is that your pre-tax IRAs have a lower spending value than the account value. If you pay about 33% to the feds and state, you are going to lose 1/3 of any withdrawal before you can spend the money. You can pay the taxes from any pot of money, but if you are under 59.5, there will be a 10% early withdrawal penalty if you withdraw from YOUR OWN IRA to pay the taxes. There is no penalty on withdrawals from Inherited IRAs.
Your explanations makes sense to me (I am over 59.5 y.o.).
Thank you very much for your detailed and informative replies.
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