Roth conversions can be a powerful financial planning tool. However, the taxes around Roth conversions can be confusing. This post will discuss how Roth conversions are taxed.
What is a Roth conversion?
There are two different types of IRAs: traditional and Roth. For a traditional IRA, the contributions are often (but not always) tax-deductible, but distributions are typically taxed as regular income. Roth IRAs are funded with after-tax funds and distributions are not taxed.
A Roth conversion is where an account holder with a traditional IRA moves funds or securities from within their traditional IRA to a Roth IRA. This allows the holder to take advantage of the especially attractive features of the Roth IRA, namely that the funds will never be taxed.
The catch is that a Roth conversion will often trigger taxes. So, the decision must be made whether it makes sense to pay the taxes now for the privilege of the funds not being taxed in the future. Roth conversions are not recommended in all circumstances, but in the right circumstances, that can be powerful. Their impact will only be magnified if tax rates increase in the future – which I personally think is likely given the fiscal situation the country is in. The decision of whether or not to convert can be a little complicated and is beyond the scope of this article, which will focus on the tax implications.
Roth conversion taxes when all contributions were tax-deductible
If all contributions made to the traditional IRA were tax-deductible, then the tax impact of a conversion is straightforward – the amount converted is all taxable as regular income in the year of the conversion.
For example, Reid contributed $30,000 to a traditional IRA over the last 10 years. All of his contributions were tax-deductible. This year, Reid decides to convert $20,000 of his traditional IRA to a Roth IRA. He will pay regular income tax on this amount. If he is in the 22% federal tax bracket, he will pay $4,400 ($20,000 * 22%) in federal income taxes on the conversion.
Taxes when non-deductible contributions were made
The taxation of a Roth conversion gets more complicated when non-deductible contributions were made to the traditional IRA. A non-deductible contribution means after-tax funds are contributed to the traditional IRA. When the conversion happens, the whole amount is not taxable, because some of the contributions were made with after-tax funds.
Unfortunately, you cannot choose to just convert the after-tax contributions. The conversion must be “pro-rata” or proportional to the portion of the after-tax contributions to the total value of all the account holder’s IRAs. It is also important to note that all of an individual’s IRAs are counted together – the pro-rata rule cannot be avoided by having separate IRA accounts.
For example, let’s say that Reid made $4,000 in non-deductible contributions to his traditional IRA. During the year, he converted $2,000 to a Roth IRA. The remaining balance in his traditional IRA at the end of the year is $10,000. Again, because non-deductible, after-tax contributions were made to the traditional IRA, not all of the $2,000 conversion will be taxable. Only $1,333 of the $2,000 conversion is taxable.
This is calculated by taking the $4,000 non-deductible contribution and dividing it by the ending traditional account balance of $10,000 plus the amount converted during the year of $2,000 (distributions other than conversions would also be added back). So $4,000 / ($10,000 + $2,000) = 0.333. This is the percentage of the conversion that is non-taxable and the remainder or 0.667 (1 – 0.333) is taxable. This results in $1,333 being taxable ($2,000 * 0.667).
If you have any comments, questions, or ideas for future posts, please let me know
I hope you found this post helpful and educational. If you have any comments, questions, or ideas for future posts, please let me know. You can reach me directly via email at crawford@ulmerfinancial.com.
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