In last month’s article, I wrote about the mistaken idea some people have that they earn too much to benefit from a Roth IRA. The Tax Increase Prevention and Reconciliation Act, passed by Congress in 2005, effectively opened up a legal avenue to make contributions to a traditional IRA, and then convert all or part of the funds to a Roth.
Let’s dig a little deeper and discuss how to calculate the tax on such conversions.
When you convert traditional IRA funds (or SEP IRA funds and SIMPLE IRA funds) to a Roth IRA, you are liable to pay tax as if you received a distribution, but with one important difference – the 10-percent early distribution tax doesn’t apply, even if you’re under age 59-and-a-half. However, the IRS may recapture this penalty tax if you make a nonqualified withdrawal from your Roth IRA within five years of your conversion.
If you’ve made only nondeductible (after-tax) contributions to your traditional IRA, then only the earnings, and not your own contributions, will be subject to tax at the time you convert the IRA to a Roth. But if you’ve made both deductible and nondeductible IRA contributions to your traditional IRA, and you don’t plan on converting the entire amount, things can get complicated.
That’s because under IRS rules, you can’t just convert the nondeductible contributions to a Roth and avoid paying tax at conversion.
Instead, the amount you convert is deemed to consist of a pro rata portion of the taxable and nontaxable dollars in the IRA.
For example, assume that your traditional IRA contains $350,000 of taxable (deductible) contributions, $50,000 of nontaxable (nondeductible) contributions, and $100,000 of taxable earnings. You can’t convert only the $50,000 nondeductible (nontaxable) contributions to a Roth, and have a tax-free conversion. Instead, you’ll need to prorate the taxable and nontaxable portions of the account. So in the example above, 90 percent of each distribution from the IRA (including any conversion) will be taxable, and 10 percent will be nontaxable.
You can’t escape this result by using separate IRAs. Under IRS rules, you must aggregate all of your traditional IRAs (including SEPs and SIMPLEs) when you calculate the taxable income resulting from a distribution from (or conversion of) any of the IRAs.
Some experts suggest that you can avoid the pro rata rule and make a tax-free conversion if you take a total distribution from all of your traditional IRAs, transfer the taxable dollars to an employer plan like a 401(k) (assuming the plan accepts rollovers), and then roll over (convert) the remaining balance (i.e., the nontaxable dollars) to a Roth IRA. The IRS has not yet officially ruled on this technique, so be sure to get professional advice before considering this.
Is this strategy is right for you? It will depend on your current and projected future income tax rates, the length of time you can leave the funds in the Roth IRA, your state’s tax laws, and how you’ll pay the income taxes due at the time of conversion.