Plenty of potential pitfalls and booby traps.
Converting taxable income into nontaxable income is something all taxpayers are eager to do. The backdoor Roth IRA is one of those options — but there are state and federal tax pitfalls to converting money from a traditional IRA or a qualified retirement account ) to a Roth IRA.
What’s the appeal of moving money from a traditional IRA to a Roth IRA? In a traditional IRA, contributions may be tax-deductible, but withdrawals are taxed as income. In a Roth IRA, contributions are made with after-tax money, but withdrawals are tax-free. In both cases, earnings grow tax-free, and penalty-free withdrawals are allowed beginning at age 59 ½.
For example, taxpayer A has $45,000 in an IRA and makes a $5,000 nondeductible contribution to the same IRA, which gives it a balance of $50,000. If Taxpayer A withdraws $5,000 from the IRA and rolls it into a Roth, $500 would be nontaxable x $5,000 withdrawn as part of a conversion) but $4,500 would be taxable at her marginal tax rate on that year’s return.
The 10% additional tax for an early distribution from an IRA doesn’t apply if the conversion is completed within 60 days through a rollover.Pitfall 2: The timing of a conversion to a Roth can have hidden costs. If a taxpayer makes the conversion within a year or two of retirement or after beginning to collect Social Security benefits, the added income from the conversion can easily increase the cost for Medicare part B for both the taxpayer and spouse’s Medicare Part B cost.
But rules in other states can be a giant headache. New Jersey and Massachusetts don’t allow a taxpayer to deduct contributions to an IRA even if the contribution is deductible for federal income taxes. So these taxpayers must determine not only their taxable and nontaxable portion for their federal tax return but also must separately determine their taxable and nontaxable portion for their state tax return, which is different.
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