Conversion from traditional IRA to Roth IRA is a very simple process but there are a couple of things you should know beforehand. First off, there is a big difference between a traditional IRA and a Roth IRA. While traditional IRA contributions are tax-deferred while Roth IRA is exempt, the tax-deferred. This makes the conversion taxable.
There is one method that can benefit you though. If you know your exact taxable income or just estimate it, you can convert only a portion that would not increase your tax rate.
Assume your taxable income is $50,000 for 2020. This places you in the 22% tax bracket. If you were to contribute more than $34,200, your tax rate will go up to 24%. You most certainly wouldn’t want that. The bottom line here is to make sure the amount you convert is manageable as far as taxes are concerned.
Roth IRA Conversion Tax
Overall, as given in the example above, your taxable income will suddenly increase. The best thing you can do to avoid paying more taxes is to calculate your taxable income early on and add the Roth IRA conversion amount. If the amount you added on your taxable income moves you to a higher tax bracket, convert less of your traditional IRA contributions to your Roth IRA.
See the current federal tax brackets here.
Knowing which tax bracket applies to you is important. Once you know your tax rate, see the maximum amount for that marginal tax rate. Since you’re going to pay tax on the money you’re converting at the end no matter what, make sure you don’t move to a higher bracket. This is especially good if you’re converting early on. For those who made significant contributions to a traditional IRA and now want to convert it to a Roth IRA, give yourself some time to make sure you don’t pay more tax than necessary.
While you can use the simple formula above, use this calculator to help you see everything clearly.