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Why the Roth IRA?
As a single taxpayer, if you have earned income (modified AGI) of $125,000 or greater, you cannot contribute to a Roth IRA. For married individuals, this amount is $183,000 (these current limits for 2012 can be indexed upward annually). However, anyone can contribute up to $5,000 per year (indexed for 2012) to a Traditional IRA regardless of the amount of his or her earned income, just as long as his or her contribution does not exceed the lesser of $5,000 or the amount of his or her earned income. (Age 50 or older also has a $1,000 additional catch-up amount).
Traditional IRA Vs. the Non-Deductible IRA
Up to certain earned income limitations (that typically change annually), taxpayers in lower tax brackets can receive an IRA contribution deduction on their federal tax returns for deposits made to a Traditional IRA for the year. If you happen to earn over the IRS limits, you can still contribute to an IRA, but you will not be entitled to an IRA contribution deduction on your tax return. This is known as a non-deductible IRA contribution," which requires you to file Form 8606 with your tax return listing the contribution as such. Since you never received a tax deduction for these contributions, these "non-deductible" contribution amounts are not taxed when withdrawn from the IRA account and they are commonly known as "basis."
Converting IRAs to Roth IRA
In 2010, Congress eliminated the $100,000 income limit on Roth IRA conversions. This allows Traditional IRA owners in all tax brackets to convert their IRAs to Roth and pay tax now to receive tax-free benefits in retirement. What if all of your IRA savings are comprised of non-deductible IRA contributions? If this is the case, then you can convert your entire Non-deductible IRA to a Roth IRA, and you'll only have to pay tax on the earnings portion. For example, Susan Smith is in a 30% tax bracket this year and she only has one IRA worth $100,000. The IRA consists of $90,000 in non-deductible contributions and $10,000 in earnings. If she decides to convert the entire IRA to Roth, she would only have to pay tax on the earnings portion ($10,000). At a 30% tax rate, she would owe $3,000 in tax to convert the entire $100,000 to Roth.
If Smith had no earnings in this IRA, the entire $100,000 (all non-deductible contributions) could be converted with no tax liability. When earnings are present, the owner must consider if it would be more beneficial to him or her, or his or her heirs, to pay the tax due now, considering that the future benefit would be tax-free.
Where It Gets Tricky
When you have an IRA that contains normal contributions, non-deductible contributions and earnings, the rules of conversions are more complex. It would be fantastic if you could simply single out the non-deductible contributions and only convert that portion to the Roth tax-free. However, we all know the IRS quite well and it wants its piece of the pie. Let's take a look at the special tax treatment of partial conversions for owners with multiple IRA accounts or IRAs with both deductible and non-deductible contributions.
John Doe, a 30% taxpayer, has a Traditional IRA worth $200,000 on Dec. 31, 2012, of which $100,000 is non-deductible contributions. Doe wants to convert $100,000 of this IRA to Roth. Because Doe has $100,000 of non-deductible contributions in this Traditional IRA, you would think that he could convert the $100,000 of non-deductible contributions tax-free. Unfortunately, the IRS has a special formula that must be followed if you own an IRA with normal contributions.
Here's how it works:
Tax-free Percentage = Total Non-deductible Contributions divided by
(Sum of year-end value of all IRA accounts + Conversion Amount) = $100,000/($200,000 + $100,000) = $100,000/$300,000
Tax-Free amount of Conversion = 33.3% (or $33,333)
Therefore, if John converts $100,000 to the Roth, he will have $33,333 ($100,000 x 33.3%) that is not-taxed and $66,667 ($100,000 x 66.7%) that will be taxed at his 30% tax rate.
The Bottom Line
As you research this topic, you'll find many financial planner recommendations and articles on this subject are written incorrectly. The common misconception is that you can single out the non-deductible contributions and convert them specifically tax-free. Another misconception is that you simply divide the non-deductible contributions by the total value of the IRAs and this is the tax-exempt amount percentage. Unfortunately, the formula is a little more complex than both methods just mentioned. Now you know the rules, and doing the calculation correctly will keep the IRS off your back.
This story was originally published by Investopedia.