Converting money from a traditional IRA to a Roth IRA promises tax-free distributions in the future, but you'll have to pay taxes on the conversion in the year that you make it. Conversions make the most sense in years that you have less income, so that you can lock in a lower income tax rate than in a year when you'll pay a higher tax rate.
Generally, the entire amount of your conversion from a traditional IRA to a Roth IRA counts as taxable income because you're moving money from a tax-deductible retirement plan to a plan that accepts only after-tax contributions. If you didn't have to pay taxes on the conversions, you'd be getting a double tax break because you'd get a deduction for contributing it to a traditional IRA and then not have to pay taxes when you took it out of the Roth IRA. However, you don't have to pay any early withdrawal penalties when you convert money to a Roth IRA.
Calculating the Taxable Portion
If you've made nondeductible contributions to a traditional IRA, you'll have to calculate the taxable portion of your traditional-to-Roth IRA conversion. If you convert your entire traditional IRA, you just need to know the value of the nondeductible contributions in the account. If you're converting a portion of your traditional IRA, you need to know the percentage of the value of the nondeductible contributions in the traditional IRA. For example, if 20 percent of the value of your traditional IRA is nondeductible contributions, 20 percent of your conversion is tax-free.
The tax rate charged on your Roth IRA conversion depends on your income tax bracket for the year; there isn't a specific tax rate applied to all conversions. When you file your taxes, the income from the Roth IRA conversion gets added to all of your other income so it is taxed at your marginal rate. For example, if you fall in the 28 percent tax bracket and $10,000 of your contribution is taxable, you'll owe an extra $2,800 in taxes.
Because your conversion is taxed at your marginal tax rate, you'll save money on the conversion by converting in a year that you have less other income so the money falls in a lower income tax bracket. For example, if you take a year off from working so you don't have any other income, you'll pay little or no tax on your conversion. However, make sure that you have money to cover whatever tax does come from the conversion.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."