Oh what a great year for debate on Roth IRA's and Roth IRA Conversions! Roth IRAs are a great tool for building up retirement savings, but some things have changed for conversions.
I recently received a comment from a reader that I thought garnered a little more attention. Here's what the reader asked:
My wife and I had traditional non-deductible IRAs and converted at the beginning of this year. We assume that the Roth conversions wouldn’t cause us any tax liability since our contributions to the traditional IRAs exceeded their values at the time of the conversion. Have you heard anything about the tax implications of Roth conversions from traditional non-deductible IRAs?
So what we know from the statement above is that they converted to Roth IRAs from Traditional, non-deductible IRAs. We also know that there were no gains in the account, meaning it was strictly contributions – and they're wondering what their tax implications will be on this move.
This is a GREAT question!
Table of Contents
- What is a Traditional Non-Deductible IRA
- What are the Income Limitations for Deductible IRAs
- What are the Tax Implications of a Non-Deductible IRA to Roth IRA Conversion
- The Uh-Oh
- What You Need to Do
What is a Traditional Non-Deductible IRA
Let's define what a traditional, non-deductible IRA is so that we are all on the same page.
Generally speaking a traditional IRA allows money to be contributed pre-tax, which means that you get to take a deduction for it. It's deductible off of your gross income. This also means that when you withdraw from your IRAs this money becomes taxable at that time!
So, for example, you put in $5,000 to a traditional IRA, you are allowed to subtract $5,000 from your income, which in turn gives you less reportable income to pay taxes on.
Of course the IRS has some funky little rules to spoil how much you can stash into traditional IRAs.
Basically, if you already participate in an employer-sponsored retirement plan – meaning you have a 401k, 403b or SEP IRA etc. – AND you make too much money then you get phased out of your “deductibility” of the IRA and the contributions then turn into non-deductible IRA contributions!
It's as if you put after-tax money into the IRA.
What are the Income Limitations for Deductible IRAs
Let's take a look at the rules for tax year 2009:
- If you are a single filer and are covered by an employer-sponsored retirement plan you begin getting phased out of your deductible IRA contributions if you have an adjusted gross income (AGI) between $55,000 and $65,000.
- If you're married filing jointly, covered under an employer-sponsored retirement plan then you begin getting phased out between $89,000 and $109,000 AGI.
If you're making more than this then your entire contribution to the Traditional IRA is non-deductible!
What are the Tax Implications of a Non-Deductible IRA to Roth IRA Conversion
Back to the question at hand – how will this affect me on my taxes?
So here's a couple things to consider:
- What is your basis (contributions to the IRA) and what is the earnings amount? In the reader's case they didn't have any gains to worry about. But if they did, they'd have to pay tax on the earnings portion.
- If you had no other IRAs in place (including SEP, SIMPLE and Traditional) then you're good to go – no taxes due!
- If you did have other IRAs in place, then you may not be in as great a shape as you thought – you may owe Uncle Sam!
Here's what I mean on the last two:
The rule with a Non-deductible IRA is that you MUST aggregate all your non-Roth IRAs together as one big account when doing a Roth conversion in order to determine the tax liability.
Here's an example:
Let's say you have two IRAs with a total value of $30,000. One is a traditional IRA that has a $15,000 balance and all of that is pre-tax.
The other is a non-deductible IRA that includes $15,000 of nondeductible, or after-tax, contributions and no earnings as in the reader's case.
If you decide to convert all $30,000 of your IRA money, then $15,000 (the amount you contributed to the non-deductible IRA on an after-tax basis) would not be taxable since you've already paid the tax on that money.
But the remaining $15,000 would be taxable because Uncle Sam hasn't got his piece of that pie yet (it's pre-tax contributions plus earnings that have not been taxed yet)
Let's say you only want to convert your non-deductible IRA funds since there are no gains and you've already paid tax on the contributions – what happens?
In theory, this is a great strategy, but as mentioned, you have to consider all non-Roth IRAs as one big pie.
In the example above, your already-taxed nondeductible contributions of $15,000 account for 50% of your total, while the $15,000 of pre-tax deductible contributions and investment earnings represent the other 50% of your $30,000 IRA pie.
Whether you convert the entire $30,000 or just a slice of it, 50% is considered taxable income.
It doesn't matter where you take that slice from (non-deductible or pre-tax) – each has the same ingredients of taxable and nontaxable money as the whole!
What You Need to Do
If you find yourself in this situation, you'll need to fill out IRS form 8606 and wade through the instructions and the mire!