Undoubtedly the Roth IRA has some strong advantages over the Traditional IRA: The Roth offers tax-free withdrawal of contributions and earnings upon you reaching retirement and it has no Required Minimum Distribution (RMD) when you hit age 70½. So if, for whatever reason, you would like to turn your Traditional IRA into a Roth, it’s doable (see Converting Traditional IRA Savings to a Roth IRA for a discussion of the pros and cons).
At one point, there were restrictions on conversions, but In 2010, Congress eliminated the $100,000 income limit on Roth IRA conversions. This allows Traditional IRA owners in all tax brackets to convert their accounts. Basically, you can convert the Traditional IRA contributions to a Roth IRA; however, a portion of the amount you convert to the Roth will be subject to income tax.
Conversions: The Basics
First, a quick review of the basics. Up to certain earned income limitations (that typically change annually), taxpayers in lower tax brackets can receive an IRA contribution deduction on their federal tax returns for deposits made to a Traditional IRA for the year. If you happen to earn over the IRS limits, you can still contribute to an IRA, but you will not be entitled to an IRA contribution deduction on your tax return. This is known as a “non-deductible IRA contribution,” which requires you to file Form 8606 with your tax return listing the contribution as such. Since you never received a tax deduction for these contributions, these “non-deductible” contribution amounts are not taxed when withdrawn from the IRA account and they are commonly known as “basis.”
(Form 8606 must be filed for any tax years that you distribute assets from your Traditional IRA if any of your Traditional IRA balances include non-deductible contributions. IRS Form 8606 is used to help you determine the taxable portion of your distribution or conversion.)
The Conversion Formula
When your Traditional IRA balance consists of deductible and non-deductible contributions, any amount distributed or converted from the Traditional IRA is pro-rated to include a taxable and non-taxable portion of the assets.
You may figure the taxable amount by using the following formula:
(Total Deductible Contribution/Total IRA Balance) x Distribution/Conversion Amount = Non-Taxable Amount
Let’s say you have non-deductible contributions of $8,000 in a Traditional IRA that have grown to $100,000. The taxable amount would be:
(8,000 ÷ 100,000) x 8,000 = 640
Of the $8,000 that you convert, $7,360 would be taxable ($8,000 – 640 = $7,360).
This rule applies even if the deductible amounts and non-deductible amounts are held in separate Traditional IRAs. Also note that if you maintain multiple Traditional IRAs, their total balances must be combined in the formula above to determine the amount that can be excluded from income (i.e. the amount that is non-taxable).
A Conversion Example
What if all of your IRA savings are comprised entirely non-deductible IRA contributions? If this is the case, then you can convert your entire non-deductible IRA to a Roth IRA, and you’ll only have to pay tax on the earnings portion.
For example, Susan Smith is in a 30% tax bracket this year and she only has one IRA worth $100,000. The IRA consists of $90,000 in non-deductible contributions and $10,000 in earnings. If she decides to convert the entire IRA to Roth, she would only have to pay tax on the earnings portion ($10,000). At a 30% tax rate, she would owe $3,000 in tax to convert the entire $100,000 to Roth.
If Smith had no earnings in this IRA, the entire $100,000 (all non-deductible contributions) could be converted with no tax liability. When earnings are present, the owner must consider if it would be more beneficial to him or her, or his or her heirs, to pay the tax due now, considering that the future benefit would be tax-free.
Where It Gets Tricky
When you have an IRA that contains normal contributions, non-deductible contributions and earnings, the rules of conversions are more complex. It would be fantastic if you could simply single out the non-deductible contributions and only convert that portion to the Roth tax-free. However, we all know the IRS quite well and it wants its piece of the pie. Let’s take a look at the special tax treatment of partial conversions for owners with multiple IRA accounts or IRAs with both deductible and non-deductible contributions.
John Doe, a 30% taxpayer, has a Traditional IRA worth $200,000 on Dec. 31, 2018, of which $100,000 is non-deductible contributions. Doe wants to convert $100,000 of this IRA to Roth. Because Doe has $100,000 of non-deductible contributions in this Traditional IRA, you would think that he could convert the $100,000 of non-deductible contributions tax-free. Unfortunately, the IRS has a special formula that must be followed if you own an IRA with normal contributions.
Here’s how it works:
Tax-free Percentage = Total Non-deductible Contributions divided by
(Sum of year-end value of all IRA accounts + Conversion Amount) = $100,000 ÷ ($200,000 + $100,000) = $100,000 ÷ $300,000
Tax-Free amount of Conversion = 33.3% (or $33,333)
Therefore, if John converts $100,000 to the Roth, he will have $33,333 ($100,000 x 33.3%) that is not-taxed and $66,667 ($100,000 x 66.7%) that will be taxed at his 30% tax rate.
The Bottom Line
The common misconception is that you can single out the non-deductible contributions and convert them specifically tax-free. Another misconception is that you simply divide the non-deductible contributions by the total value of the IRAs and this is the tax-exempt amount percentage. Unfortunately, the formula is a little more complex. But now you know the rules, and doing the calculation correctly will keep the IRS off your back. Consult with your tax professional to ensure that the appropriate forms are filed and the calculations are accurate.