Helping readers with the likely taxes on a Roth conversion was a fun answer to give on Quora. As more and more people come to see the value of the Roth, this becomes increasingly pertinent.
And with likely much higher taxes on the way (for anyone with a decent income), and the desire to keep more of our cash and live a more free lifestyle, there is MUCH to like about owning a Roth IRA. However, many of you might be worried about the taxes on a Roth conversion I’d be willing to bet!
Here is my answer on Quora linked below and below find the transcript. Hope you find this helpful!
Full Answer – What Taxes are Paid When You Convert to a Roth IRA?
If you have a traditional IRA or 401k, and you are converting to a Roth IRA, you may owe taxes or not on that conversion. Here are some scenarios:
- Typical one, you have an IRA that you rolled over from an old job. It’s likely all of the money in that rollover IRA was invested “pre-tax” – meaning it came out of your paycheck at the old job before you paid taxes on your pay that week. Any of this money converted would be 100% added to your taxable income in the current tax year.
- Another typical one – you have an IRA that you contributed to over the years. In this case, there are people who did this and took deductions on the contributions, and some people who, at least some years, did not take deductions. The non-deductible contributions are considered “basis” in this account. Conversions are pro-rata, so that if the account is 100% pretax, all of the conversion dollars are added to your taxable income this year. if the account basis is 40% of the account, then only 60% of funds converted will be added to taxable income. Hope you followed here.
- Increasingly typical – non deductible IRA is funded with the express intent of converting to a Roth IRA immediately. In most cases, the amount contributed then converted is the same, and since it is 100% basis, no tax on the conversion.
The Big Catch on Taxes on a Roth Conversion
the big catch from a tax perspective is that little pro-rata rule mentioned above. In the case above it was a positive. Let me show you where it will be a negative.
The tax code looks at all of your traditional IRAs as one big balance. meaning if you have an IRA at Fidelity and another at Vanguard, the tax code looks at these as one big IRA balance. *Note: They do not look at Roth IRAs and traditional IRAs as one big balance.
Therefore – and this is a trap that gets some people – if you own a rollover IRA lets assume with a balance of $95,000, and you open another IRA of $5,000 with the intent of doing the Roth conversions and avoiding tax (as in example 3 above), you will still pay tax. Here’s why: the tax code looks at the $95,000 + $5,000 as one big IRA of $100,000. When you go to convert the $5,000 to the Roth, the formula is that 5,000/100,000 or 5/100 or 1/20th of the conversion amount will be considered basis. You will owe tax on 19/20ths of the balance converted or $250 will be basis and not taxed on conversion, while $4,750 will be taxable balance and added to your taxable income this year.
The tax code does not separate that rollover IRA from the new IRA you. created for Roth conversions. One way to avoid this (which has its own pros and cons) is to roll that rollover IRA to your current employer’s 401k. 401k and IRA are not considered like money under the tax code and each balance would have its own conversion, RMD and other requirements.
This can get complicated (we can help answer Qs) but once you work it around in your head it gets easier.