Don't convert traditional individual retirement account assets to a Roth unless you have a good estimate of the tax bill. That means you need to understand the tax rules associated with a conversion. Bottom line: Stay away from using IRA assets to pay taxes and make sure you don't stumble into a higher tax bracket.
Converting assets from a traditional IRA to a Roth IRA will carry the same tax ramifications as any other IRA distribution with one key exception. If you are not yet 59 1/2, the 10 percent early withdrawal penalty will not be assessed on a conversion. However, you will be charged the 10 percent penalty on any amount of IRA assets withdrawn to pay the conversion tax bill.
Assets rolled over to an IRA from an employer's 401(k) or similar plan and all tax-deductible IRA contributions plus tax deferred dividends and capital gains -- even unrealized capital gains -- will be taxed as ordinary income in the year you convert them. The value of securities will be pegged to their closing prices based on the day you withdrew the assets from the traditional IRA to initiate the conversion.
If some or all of your IRA contributions were nondeductible, they can be converted tax-free to a Roth. However, any dividends or asset growth from those contributions still carry a tax liability. Because the IRS does not allow you to separate out the nontaxable part, your conversion can be only partly untaxed.
If you have both deductible and after-tax contributions as well as tax-deferred growth in your IRA, the taxable part of your conversion will be proportionate. For example, if you have $2,000 in after-tax contributions, $5,000 in deductible contributions and $3,000 in tax-deferred dividends or increased value on the day you initiate an account conversion, then 20 percent of the move will be tax-free. The remaining 80 percent will be taxed as ordinary income.
The IRS does not allow you to separate the after-tax portion of your IRA assets into a stand-alone account to provide you with a tax-free conversion. You must include the assets from all IRA accounts registered under your Social Security number, including rollover IRAs, in calculating the percentage of taxable and nontaxable assets. For example, if you have $5,000 in after-tax contributions plus $1,000 in asset growth in a traditional IRA and $94,000 in a rollover IRA, you can convert the entire $6,000 from the traditional IRA, but 94 percent of the conversion will be taxed as ordinary income.
You don't have to convert all your IRA assets or even an entire IRA account in a single transaction. You can manage your tax bill through a partial conversion or a series of conversions over several years. In the above example, for instance, you might include all of the traditional IRA plus $14,000 from the rollover IRA for a $20,000 conversion. However, the taxable percentage of the conversion would remain the same. That means 94 percent — $18,800 — would be treated as ordinary income on your tax return.
The amount you pay on your IRA-to-Roth switch depends on your tax bracket, and that can change when you increase your taxable amount through a conversion. For example, if you're at the top of the 15 percent bracket before a conversion, most of the converted amount may be taxed at the 25 percent rate.
- Internal Revenue Service: Publication 590, Individual Retirement Arrangements (IRAs)
- Kiplinger: What You Need to Know About Roth Conversions
- Morningstar: IRA Conversion Fact Sheet
- Morningstar: IRA Dos and Don'ts
- MarketWatch: Rethink that Roth – 12 Traps to Avoid When Converting to a Roth IRA
- Morningstar: Backdoor Roth IRAs Could Cost Some Investors at Tax Time
- Tax Guide for Investors: How Much Conversion Tax?
- Tax Guide for Investors: Conversion Consequences
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