Roth Conversion? Yes, You Should Think About This, That and the Other Thing

Q: I will be converting my individual retirement account to a Roth IRA this year and know that I will owe taxes for 1998 on one-quarter of the amount converted. What I don’t know is when those taxes must be paid to avoid any penalties from the Internal Revenue Service. Can you help?

--P.J.

A: Our experts say they expect the traditional IRS tax withholding and prepayment requirements to apply to Roth conversions.

To avoid underpayment penalties, taxpayers must have withheld or prepay the lower of either 100% of their prior year’s tax obligation or 90% of their current year’s tax obligation.

How can you meet this obligation? If you’re employed, you can change your W-4 statement to increase the amount withheld from your paycheck by your employer. If you’re not employed, you can file an estimated tax payment directly to the IRS (and don’t forget about the state of California’s Franchise Tax Board, which has similar requirements).

What you want to avoid is having the taxes paid from the IRA you are converting to a Roth IRA, for two important reasons:

1. You will be slapped with an early-withdrawal penalty of 10% by the federal government and 2.5% by the state of California on any money taken out of your IRA, regardless of how it is used. (Getting hit with a penalty to pay your taxes is something too ignominious to contemplate. Don’t go there.)

2. Taking money out of your IRA to pay the taxes will reduce the amount you are transferring into an account that will generate tax-free earnings. Remember, getting tax-free earnings is the most important reason you are making this transfer.

If you can’t possibly come up with the money for the tax bill without tapping the IRA funds themselves, perhaps you should reconsider whether a Roth transfer makes sense for you. Or perhaps you should consider transferring only a portion of your IRA to a Roth to keep your tax obligation under control.

*

Q: I want to convert my IRA to a Roth but will exceed the $100,000 limit on adjusted gross income this year, so I can’t take advantage of the opportunity to spread the tax obligation on the transfer over the next four years. Still, I am interested in the transfer and have taken steps to ensure that I meet the income limit next year, even though it means paying taxes on the conversion in one lump sum. If I take out a home equity loan to make the tax payment, will interest on the loan be tax-deductible?

--Y.B.

A: The traditional rules covering deductibility of mortgage interest apply here.

Taxpayers are allowed to deduct the interest on mortgages of up to $1 million for the purchase, construction or improvement of a principal or second home. They are also allowed to deduct the interest on home equity loans of up to $100,000 on their principal residence, regardless of how that money is used.

Assuming that you would not exceed the $100,000-loan limit, the law would allow you to deduct the interest you pay on a home equity loan whose proceeds were used to pay a tax bill on a Roth IRA conversion.

*

Q: I am interested in converting my IRA to a Roth IRA. I know that I will not have to pay taxes on the IRA contributions I made with after-tax money for which I did not claim a tax deduction. My problem is that I made both nondeductible and deductible IRA contributions over the years and am not sure I know in which years I did which. Does the IRS know? Can they help me figure it out?

--E.T.

A: You will need to request copies of your previous years’ tax returns from the IRS, and each return you want is going to cost you $23. It should be relatively easy to get copies of returns for the past three years. Older returns could prove more difficult to get, because the IRS says it has already sent those to its archives. Your best bet is to start by calling the IRS’ taxpayer help line at (800) 829-1040.

*

Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or e-mail carla.lazzareschi@latimes.com