Converting your traditional IRAs to Roth IRAs can be a wise choice. But, since you don’t pay taxes on your contributions to a traditional IRA like you do with a Roth, how much will you pay in taxes if you convert?
In short, when you convert contributions from a traditional IRA (or other pre-tax retirement account) into a Roth IRA, you will pay taxes on the pre-tax portion of the converted funds. This includes any tax-deductible contributions you made to the traditional IRA, as well as any earnings on those contributions.
What if you contributed to your IRA after-tax?
Some people are “phased out” of taking tax deductions on their IRA contributions due to their income level.
As a general statement, if you are making after-tax, non-deductible contributions to your IRA, you won’t get taxed on those dollars a second time on the conversion. However, there is a catch…
How are your IRA taxes and conversions tracked?
Thanks to one of my customers, I learned you can really go down a rabbit hole researching this one. I hope I was able to help you understand traditional to Roth IRA conversions.
To ensure you don’t get taxed twice on non-deductible IRA contributions when converting to Roth, you should file IRS form 8606 each year that you make non-deductible IRA contributions. 8606 will track your non-deductible basis.
Is this all a pain? Totally. Is it worth it? Absolutely.
As mentioned above, saying that you won’t be taxed twice is not the whole story. Our favorite Uncle doesn’t want everyone to be able to only specify those tax-free dollars on conversion. Therefore, you are taxed on a pro-rata portion of the amount you converted versus the amount of total DEDUCTIBLE contributions that were made into your IRA in the past.
So, how much will you pay on your IRA contributions?
For simplicity purposes, I’m going to use some round numbers. Say you have a total of $100k in your IRA account. Of this $100k, $80k is old contributions for which you took a deduction, and the other $20k is after-tax contributions. Therefore, according to the pro-rata rule, 20% of any conversion would be tax-free, and the other 80% would be taxable.
Say you are converting a $7k traditional IRA to a Roth IRA. If 20% of your IRA contributions were made after tax, $1400 of the $7k conversion would be tax-free, and the other $5600 would be taxable on conversion.
In conclusion
Converting money from a traditional IRA to a Roth is a great long-term strategy for tax-free income in retirement. However, you need to be aware of the potential tax ramifications along the way. Conversions are not as straightforward as they seem!
Lastly, I need to remind you that I’m not a CPA, nor did I play one on TV, and I also didn’t sleep in a Holiday Inn Express last night. Therefore, it is always a good idea to double-check with your tax advisor/CPA based on your specific situation.
Bright Road Wealth Management, LLC (“BRWM”) is a Registered Investment Adviser (“RIA”). Registration as an investment adviser does not imply a certain level of skill or training, and the content of this communication has not been approved or verified by the United States Securities and Exchange Commission or by any state securities authority. BRWM renders individualized investment advice to persons in a particular state only after complying with the state’s regulatory requirements, or pursuant to an applicable state exemption or exclusion. All investments carry risk, and no investment strategy can guarantee a profit or protect from loss of capital. BRWM is not an accounting firm.
