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I am aware of the fact that we have to pay taxes on the amount we convert from Traditional IRA to Roth IRA. However, I would like to find out if we have to pay FICA taxes on the conversion.

General Paycheck

Gross Income - State/Fed Taxes - FICA = Net Paycheck (ignoring other pre/post deductions)

Traditional IRA to Roth IRA Conversion

Option 1. Amount converted - State/Fed Taxes = Net Converted to Roth

Option 2. Amount converted - State/Fed Taxes - FICA= Net Converted to Roth

Which option is correct?

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You do not have to pay FICA taxes when you do an IRA Traditional to Roth conversion. The reason is FICA taxes were not reduced when you made your Traditional IRA contributions. (Note the same is also true for Traditional 401k contributions- you pay FICA taxes before you make any kind of 401k contributions, so no additional FICA taxes are owed on a 401k Roth conversion either.)

As for the 2 options you listed, neither is correct. The amount you convert is typically the full amount, and it is treated as income meaning you pay the taxes separately just like you do for other income. Although you could pay the taxes from the IRA funds if you absolutely had to, it's definitely better to maximize the amount of money in the roth for future tax free growth, so it's best to pay the taxes with other funds outside of the IRA, if you can.

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  • "Although you could pay the taxes from the IRA funds if you absolutely had to, it's definitely better to maximize the amount of money in the roth for future tax free growth" Not to mention that taking out money from the IRA would count as an early distribution, which usually has penalties. – user102008 Jun 14 '20 at 16:42
  • @user102008 actually, the way OP worded it was to pay the taxes out of the Roth after the conversion, which would not have a penalty, since contributions to a Roth IRA can be withdrawn anytime. Only distributing earnings from a Roth would incur the penalty. – TTT Jun 14 '20 at 17:08
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    Withdrawing from a conversion within 5 years of the conversion also has a penalty (at least on the part of the conversion that was taxable, which is likely all of it in this case), so unless the OP has prior Roth IRA contributions to withdraw from, it would still have a penalty. – user102008 Jun 14 '20 at 19:03
  • @user102008 excellent point! If you don't have enough to cover it in an existing Roth IRA the 5 yr rule could apply. – TTT Jun 14 '20 at 20:38
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IRA conversion is not subject to FICA and neither is distribution; both are subject to Federal income tax for sure, and maybe state (it depends on your state).

(I assume you are a US 'resident' for tax purposes, otherwise this is a good deal more complicated; see Taxation of traditional to Roth IRA conversion for non-resident !)

But you need to remember withholding is not always the same as tax.

For FICA, the actual tax is a flat rate on amounts paid by the employer (with some exceptions the employer knows about), so the withholding is almost always correct and you don't have to do anything further. There is one exception: Social Security tax only applies up to a yearly limit called the 'wage base', which is $137,700 this year but changes with inflation; if you are paid by two or more employers and the total exceeds the wage base, more SS tax is withheld than you actually were required to pay, so you can claim a refund of the extra on your income tax return; see the instructions for 1040 line 11 (note the webpage is still for 2019, when the wage base was lower). Note Medicare tax does not have this limit, and not only continues but increases at higher incomes, and that part is affected by multiple sources or joint filing, so withholding may not be correct and you may have to pay more.

For income tax on wages -- Federal for sure and most states -- withholding is an estimate. You must file a return shortly after the end of the year -- normally by April 15 (or next business day), but you can get an extension to Oct. 15 (ditto), and this year April 15 was moved to July 15 because COVID -- on which you compute your actual tax (many people have software or a preparer do this), and if your withholding was not enough you must pay the difference, in some cases plus a penalty, but if your withholding was too much you get a refund.

For income tax on an IRA conversion (OR a distribution, other than a qualified Roth distribution which is tax-free) withholding is not really even an estimate. If you do the conversion as a direct trustee-to-trustee transfer there is no withholding. You still owe the tax, and depending on the rest of your tax situation (other income, deductions, credits, and status) you may need to make estimated tax payments during the year to avoid a penalty, or you may be able to wait until next April 15 to pay.

OTOH if you do the conversion 'manually' -- i.e. you first take the money from the trad IRA and then within 60 days deposit it, identified as a conversion/rollover, to the Roth IRA -- there is flat 20% withholding. That doesn't mean your tax will be 20%; it might be more, or less. Only the withholding is 20%. But it means to actually convert the complete amount you must 'front' the 20% cash to replace the amount withheld. Then during filing season you might get some of it refunded. Conversely depending on the rest of your situation you might owe more than the 20% and might need to make estimated payments.

Alternatively, if you use the 20% withholding on non-direct, or any other money taken from the source trad IRA, to pay the tax, that money is not considered converted but rather distributed. That means it is subject to normal income tax, plus if you are under 59.5 there is an additional 10% tax unless certain special cases apply (and from your description they probably don't). So try to avoid doing that.

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