Contributed by: LynR, FreeTaxUSA Agent, Tax Pro
Are you interested in converting your traditional IRA to a Roth IRA to take advantage of its tax benefits? If so, there are tax implications to consider.
Why convert your traditional IRA to a Roth IRA?
If any of the following apply, you may consider converting your funds from a traditional IRA to a Roth IRA:
- Your income exceeds the traditional IRA deduction limits,
- You'd prefer no required minimum distributions (RMDs) in retirement, or
- You simply want your contributions to grow tax free.
Contributions to a traditional IRA may be tax-deductible depending on your filing status, whether you’re covered by an employer retirement plan, and your modified adjusted gross income (MAGI). The deduction is often a primary reason for contributing to a traditional IRA. However, you’re taxed on distributions from your traditional IRA in retirement. Traditional IRAs also require you to take an RMD each year once you’ve reached age 73.
Although a Roth IRA provides no immediate tax deduction, the distributions from your Roth IRA in retirement aren’t taxable, and your contributions and earnings grow tax free. Additionally, a Roth IRA has no RMD if you’re the original account holder.
Is converting your traditional IRA to a Roth IRA taxable?
Usually, yes. If you've made contributions to a traditional IRA in the past and claimed a tax deduction for them, converting to a Roth means you'll owe tax on both the original contributions and any earnings at the time of conversion.
However, if you contributed to a traditional IRA and were unable to take a tax deduction or chose not to take one, then the original contribution amount isn’t taxable once it’s converted. Only the earnings associated with the contribution are taxable. This is called a nondeductible contribution. It typically happens when you or your spouse are covered by a retirement plan at work and your income exceeds the IRS deduction limit.
What happens if I have both deductible and nondeductible contributions in my traditional IRA?
Commonly, you may start by making traditional IRA contributions that give you a tax deduction (pre-tax) and then your situation changes, and your contributions are no longer deductible (post-tax). In this case, your traditional IRA contains a mix of pre-tax and post-tax contributions.
If you were to convert everything in your traditional IRA to a Roth IRA, then only your pre-tax contributions and the earnings associated with all of your contributions would be taxable.
If you convert only a portion of your traditional IRA to a Roth IRA, then you must use the pro rata rule to calculate the amount of your traditional IRA contributions that will be taxable when you convert to a Roth. The pro rata rule states you must convert deductible and nondeductible contributions in the same ratio as they exist in your traditional IRA. You can’t simply convert the nondeductible (post-tax) contributions. Read this Community article to learn more about the pro rata rule.
If you aren’t sure if your contributions to your traditional IRA were deductible, look for Form 8606 with your prior tax returns. This form tracks your nondeductible contributions and conversions.
For example, say 80% of your traditional IRA balance is deductible contributions and earnings, and 20% is nondeductible contributions. If you convert part of the account to a Roth IRA, 80% of the converted amount is taxable and 20% isn’t taxable.
Summary
When considering a Roth conversion, make sure you know what kind of contributions you have in your traditional IRA. Even if all your contributions were originally deductible (pre-tax), it may still be worth considering a Roth conversion so all future earnings can be non-taxable. If you have deductible (pre-tax) contributions in your IRA, you can have your plan administrator withhold federal taxes from your funds at the time of conversion. Make sure to discuss plans to convert your traditional IRA to a Roth IRA with your financial advisor beforehand to avoid any surprises or a large tax bill come April.
Related Articles