Step one: Calculating "Income" to Report on a Roth ConversionWhen a person converts their traditional IRA to a Roth IRA, two things happen. First, the government wants to tax the current value of the funds you convert. Secondly, those funds now become your basis in a Roth IRA. Calculating the tax impact involves three steps.
1. Figure out Your Roth Conversion Income Roth conversion income is equal to the value of the traditional IRA funds on the day you convert, minus any cost basis you have in nondeductible IRAs.
For deductible IRA funds, you will report as income the current value of the funds on the day you convert to a Roth IRA. Your basis in a deductible IRA is zero, since you received a tax deduction for your savings contribution.
For nondeductible IRA funds, you will report as income the current value of the funds on the day you convert less your basis in the funds. For example, you contributed $5,000 in 2008 to a traditional IRA and received no deduction whatsoever for that contribution. Your basis in those funds is now $5,000 ($5,000 of income minus zero deduction). You then decide to convert your traditional IRA in 2010 to a Roth and the value of the IRA is now $5,500. You'll report $500 of income on your tax return ($5,500 current value minus $5,000 in basis).
In many cases, a individual will own both deductible and nondeductible IRAs. In this scenario, the tax laws mandate that your basis (in the nondeductible funds) be spread out over all traditional IRA funds (even if they are held in separate accounts at different financial institutions). A taxpayer will logically want to convert nondeductible IRA funds first (since there is less of a tax impact). However, that's not how the tax math works out. For example, let's say you contributed $5,000 to a fully deductible IRA in 2007 (which means your basis is now zero in those funds), and in 2008 you contributed $5,000 to an entirely nondeductible IRA (which means your basis in now $5,000). In this example, you have $10,000 in traditional IRA contributions with a basis of $5,000. If you were to convert all your traditional IRAs into Roth IRAs and the value of your IRA account was $11,000, then you would report as income $11,000 minus $5,000 (your basis), which would be $6,000 in income. A person with mixed traditional IRAs might think to herself: let's convert only the nondeductible IRA. Basis would still be prorated across all her accounts. Assuming the current value is $5,500 in each IRA fund and the investor converted only $5,500 from the nondeductible account, the math would still be the same: $5,500 (current value) minus $2,500 (basis prorated), resulting in income to report of $3,000. As we shall see, there are some special work strategies designed to preserve the tax-deferred status for mixed traditional IRA funds.
People can "isolate" their nondeductible IRA funds using the following strategy. Taxpayers are allowed to rollover funds from their traditional IRAs to a qualified plan such as a 401(k) or 403(b) plan. Furthermore, taxpayers can choose to rollover only their deductible traditional IRAs. By performing such a rollover, a taxpayer can move all their deductible IRAs to a 401(k) or similar plan, leaving behind only nondeductible funds in their IRA. Then, taxpayers can rollover their nondeductible funds to a Roth IRA. This preserves the basis in their nondeductible IRAs, resulting in lower income recognized on the Roth conversion. The IRS explains this rule about rolling over only deductible IRA contributions in Publication 590: "A special rule treats a distribution you roll over into an eligible retirement plan as including only otherwise taxable amounts if the amount you either leave in your IRAs or do not roll over is at least equal to your basis."
Be aware that you are allowed to perform only one rollover per year per IRA account. So if you intend to utilize this strategy to isolate nondeductible funds in your IRA, you will can do this in the same year by using the following two-step method:
- Rollover deductible IRAs to a qualified plan in a trustee-to-trustee direct transfer (which doesn't count toward the one-rollover-per-year limit), then
- Convert nondeductible IRAs to a Roth IRA via a trustee-to-trustee direct transfer (so as to avoid the mandatory 20% withholding).
Step two: Income does not (necessarily) mean Taxable IncomeIncome reported on the conversion to a Roth IRA does not always mean the income is taxable. The tax impact of reported income can be reduced through the use of various tax deductions or tax credits. Let's take one example designed to demonstrate how the math works in computing taxable income.
Abel converts an entirely deductible traditional IRA worth $5,500 to a Roth IRA in 2010. Since these funds were entirely deductible, Abel will report $5,500 in additional income on his 2010 tax return. Abel is still entitled to take various deductions or tax credits. Abel could therefore offset his $5,500 of additional income with all available deductions or he could simply pay the tax. For example, Abel could offset the Roth conversion income with $5,500 of charitable deductions or with a $5,500 business loss. I mention this because of the way the math works: Roth conversions create income, but not necessarily taxable income.
Step Three: Calculating the tax on the Roth conversionIncome reported on a Roth conversion increases income. Thus a Roth conversion could increase taxable income and could trigger various phaseouts.
An increase in taxable income is fairly easy to figure out. Take a look at the marginal tax rates for the year in which you are converting. An increase in taxable income will cost you, roughly, your marginal tax rate times the conversion value. Be aware that a Roth conversion could push you into a higher tax bracket.
Analyzing various phaseouts is a bit more complicated to figure out. Higher income could result in more Social Security benefits being subject to tax, or could trigger a phaseout or elimination of various deductions or tax credits, or could result in less of your itemized deductions being utilized, or could increase your alternative minimum tax. Hence the best way to figure out the impact of a Roth conversion on these various items is to run a projection in your tax software to analyze the tax increase resulting from a Roth conversion.