The Roth Conversion Tax Bill You Can't Pay

The pitch is simple. Pay the tax now, at today's rates, and the money grows tax-free forever. Retirees hear it from advisors, radio shows, and neighbors at the club. Some convert large amounts in a single year.

Then April comes, the tax bill is five figures, and the money to pay it was supposed to come from somewhere that did not work out. Here is how to handle that bill without making it worse.

How a conversion is taxed

Under IRC 408A(d)(3), when you convert a traditional IRA to a Roth IRA, the converted amount is included in your gross income for the year of the conversion, except for any part that represents nondeductible contributions you already paid tax on (your basis, tracked on Form 8606).

The same section says the 10 percent additional tax on early distributions under 72(t) does not apply to the converted amount itself. That is why people under 59 and a half can convert without the penalty. Keep reading, because there are two exceptions that catch people.

No more undo button

Before 2018, you could recharacterize a conversion by the extended due date of your return, effectively undoing it if the tax turned out to be more than you wanted. The Tax Cuts and Jobs Act ended that for conversions. Under IRC 408A(d)(6)(B)(iii), recharacterization does not apply to a conversion contribution for tax years beginning after 2017.

The conversion is permanent. So is the tax.

A worked example

Say a married couple in Dunedin, both 68, convert $120,000 from a traditional IRA to a Roth in November. Their usual income is $70,000 of pensions and Social Security. Nothing was withheld from the conversion and they made no estimated payments for it. The conversion alone could add well over $20,000 of federal tax, depending on their deductions and bracket, and it pulls more of their Social Security into taxable income under section 86.

If they planned to pay the tax from a brokerage account that dropped in value, or from a home sale that fell through, they now have a balance due in April with no ready cash. That is the situation this page is about. The numbers are illustrations, but the pattern is real and common.

The pro-rata rule

Retirees who made nondeductible IRA contributions years ago sometimes plan to convert only those after-tax dollars, expecting no tax. It does not work that way. Under IRC 408(d)(2), all of your traditional IRAs, including SEP and SIMPLE IRAs, are treated as one account for figuring the taxable part of a distribution or conversion, using the year-end balance. If 10 percent of your combined traditional IRA money is after-tax basis, roughly 10 percent of the conversion is tax-free and 90 percent is taxable, no matter which account the conversion comes from. The calculation is made on Form 8606, which also reports the conversion itself. A conversion bill can be larger than expected for exactly this reason.

The ripple effects retirees miss

The income from a conversion does not sit alone on your return. It can:

• Push more Social Security into taxable income under IRC 86, sometimes making 85 percent of your benefits taxable in the conversion year. See why retirees owe tax on Social Security.
• Raise your Medicare premiums two years later through Medicare's income-related surcharge.
• Reduce or eliminate the senior deduction available for 2025 through 2028, which phases out above $75,000 of modified AGI for single filers and $150,000 for joint filers.
• Trigger an estimated tax penalty under IRC 6654 if nothing was withheld or paid during the year.

Withholding from the conversion itself

Some people ask the custodian to withhold tax from the conversion. That works, but it has a cost. Any amount withheld is not converted. It is a regular distribution from the traditional IRA. If you are under 59 and a half, that withheld amount can be subject to the 10 percent additional tax, because it was distributed, not converted.

Withholding also reduces what ends up in the Roth, which undercuts the reason for converting. The cleaner approach, when possible, is to pay the tax from money outside the IRA.

The five-year trap

If you are under 59 and a half and you take converted money back out of the Roth within five years of the conversion, IRC 408A(d)(3)(F) can apply the 10 percent additional tax to that distribution. Retirees who convert, then pull money out of the Roth to pay the conversion tax, can trigger it. If you are already over 59 and a half, this particular trap does not apply.

The estimated tax problem

Conversions are often done late in the year, after the market or the tax picture becomes clear. That helps you here. IRC 6654(d)(2) lets you use the annualized income installment method, filed on Schedule AI of Form 2210, which can show that the income arrived late in the year and reduce or eliminate the penalty for earlier quarters.

Withholding is another fix. Under IRC 6654(g), tax withheld is treated as paid evenly throughout the year unless you elect otherwise. Having tax withheld from a December IRA distribution, if you are over 59 and a half, can cover earlier quarters. More in estimated tax penalties for new retirees.

When the bill arrives and you cannot pay it

File the return on time anyway. The failure-to-file penalty under IRC 6651(a)(1) is 5 percent per month, up to 25 percent. The failure-to-pay penalty is half a percent per month. Filing late turns a bad situation into a worse one.

Then pick a payment path:

1. Short-term payment plan. If you can pay within 180 days, request one online. Interest and the failure-to-pay penalty continue, but there is no setup fee for this option.
2. Installment agreement. For longer terms, request one online or file Form 9465. Balances of $50,000 or less generally qualify for streamlined terms without a full financial statement.
3. A distribution from the Roth itself. Your regular Roth contributions come out first and tax-free. Converted amounts come out next without income tax, because you already paid it, but the five-year rule above can add the 10 percent if you are under 59 and a half. Check before you do it.
4. A traditional IRA distribution. It is taxable, so you pay tax to pay tax. Sometimes it is still the least bad choice. Read should you cash out your IRA to pay the IRS? first.

For most retirees with a conversion bill, a payment plan is the realistic option. You converted because you had assets. The IRS will expect payment, not an offer, unless circumstances have changed badly since the conversion.

What not to do

Do not take a second, larger IRA distribution in a panic to pay the first year's bill without running the numbers. That distribution is taxable too, can push you into a higher bracket, and may create next year's balance due. Do not ignore the bill and hope the Roth growth makes up for it. Penalties and interest compound faster than most portfolios. Do not let the IRS decide for you by default. Choose the payment path before the notices escalate.

Penalty relief

If you have a clean three-year history, first-time abatement can remove the failure-to-pay penalty for the conversion year. The estimated tax penalty under 6654 is different. It is not eligible for first-time abatement, but the 6654(e)(3)(B) waiver for people who retired after age 62 may apply in the year you retire or the year after, if the underpayment was due to reasonable cause.

Next time

A conversion plan should answer three questions before you sign anything: how much tax this creates, where the money to pay it comes from, and when it gets paid. If your advisor did not ask, ask them. The firm's tax planning page explains how planning ahead prevents bills like this.

If you are already holding the bill, call (813) 229-7100.