Let’s review how to calculate the income to report on your Roth conversion, assuming you’ve made post-tax contributions to your traditional IRA over the years. To best demonstrate how these rules work, we’ll look at two examples:
|Example #1||Example #2|
|Total post-tax contributions, as reflected on Form 8606 attached to your federal tax return (a)||$20k||$20k|
|Total value of IRA holding post-tax contributions||$25k||$25k|
|Total value of other traditional IRAs||$-0-||$35k|
|Total value of rollover IRA||$-0-||$90k|
|Total value of SEP IRAs and SIMPLE IRAs||$-0-||$50k|
|Total value of ALL IRA accounts (b)||$25k||$200k|
|Total pre-tax dollars in ALL IRA accounts (b-a)||$5k||$180k|
|Percent of each dollar converted that is taxable to you||20%||90%|
In both examples, you have $20k of post-tax contributions within your IRAs. And in both examples, the IRA account that is holding your post-tax contributions is worth $25k.
The big difference in these two examples is that while you have no additional IRA money in example #1, you have an additional $175k held within a variety of different IRA accounts in example #2. That additional IRA money dilutes your IRA basis and, therefore, causes more of the Roth conversion to be taxable.
Let’s see what happens if you only convert the $25k IRA account that holds your post-tax contributions. In example #1, you will report 20% of the amount you converted (or $5k) as taxable, and then will have no remaining post-tax basis in your IRAs.
In example #2, you will pay taxes on 90% of the $25k converted, or $22.5k. You will then have $17.5k in post-tax IRA basis remaining that you’ll need to continue to track on a Form 8606.
When trying to determine whether it makes sense to convert your IRAs to a Roth IRA, it’s very important that you compare the total post-tax contributions you made to a traditional IRA over the years with the total value of ALL of your IRA accounts, including SEPs, SIMPLES, and Rollover IRAs.
Based on these rules, one strategy to minimize the taxes owed on the Roth conversion is to roll out your rollover IRAs to your employer sponsored 401k or 403b plans to reduce total value of IRAs. If your employer has updated their 401k or 403b plan to incorporate 2001 Tax Act, you might also consider rolling some of your non-rollover traditional IRA into your employer’s plan to bring the total value of your IRAs to be equivalent to your post-tax basis in your IRA.
We wrote about this strategy in last month’s newsletter available atwww.mdtaxes.com/news1209.html.