Due to their income, many individuals choose to make non-deductible contributions to Traditional IRAs. Some choose to convert these non-deductible contributions to a Roth IRA. This can be an attractive option since only the earnings in a non-deductible Traditional IRA are taxed upon conversion. There are no taxes assessed on the original contributions made.
Because the IRS bases tax liability on the type of contribution originally made and whether there are any earnings, it is important for individuals to analyze the balances within any Traditional IRA they are thinking about converting to a Roth IRA. If both non-deductible and deductible contributions have been made to a Traditional IRA (or if it contains earnings), then a portion of the conversion will be taxable. Unfortunately, the IRS doesn’t allow conversion of only the non-deductible portion of an IRA. The “pro rata” rules that apply to regular distributions from a Traditional IRA also apply to conversions.
So how do these rules work? First, in order to calculate the tax on a proposed conversion, add up the total current value of all of the Traditional IRAs. Then out of that total value, determine how much, or what percentage, represents non-deductible contributions made to the IRAs. This percentage is then multiplied against the conversion amount to determine the amount that is non-taxable. The remaining amount would represent the taxable portion. For example, if 60% of the total IRA balances come from non-deductible contributions and $8,000 from one of the IRAs is converted to a Roth IRA, then 60% of the converted amount (or $4,800) is not subject to taxes. 40% of the converted amount, or $3,200, is reported as income for income tax purposes.
For those who are interested in converting to a Roth IRA, but only want to convert their original non-deductible contributions and pay no taxes on the conversion, there is a strategy that may achieve this goal. If an individual’s current employer offers a qualified plan, and the plan accepts rollover assets, they may be able to reduce the balances in the Traditional IRA and minimize the effect of the pro rata rules. Pre-tax assets (such as deductible contributions, rollovers from former employer plans, and any earnings) from IRAs can be rolled into a current employer’s qualified plan, leaving only the non-deductible contributions in the Traditional or Rollover IRAs. Then these contributions may be converted tax-free to a Roth IRA! Because assets in employer-sponsored qualified retirement plans, such as 401(k) plans, aren’t included in pro rata calculations, moving all of the pre-tax IRA assets to an employer plan will allow for a conversion of the entire balance of the Traditional IRA without triggering the pro rata calculation.
For those who don’t currently have a non-deductible IRA, opening and funding one is simple. The first step is to open both a Traditional IRA and a Roth IRA. Then, fund the Traditional IRA with up to $5,500, or up to $6,500 if you are over age 50. Finally, request a Roth IRA conversion online. It’s that easy! Individuals can select to transfer the entire account or a partial amount of cash and/or securities. We will not liquidate any securities, but instead will transfer them in-kind. The movement of assets from the Traditional IRA to the Roth IRA will be processed within 1 – 2 business days. Or individuals can call into our Customer Service department or visit one of our branches and they can process the request over the phone or in-person just as easily. There are no forms to sign and mail.