Roth Conversion of Non-Deductible IRAs

In a number of posts, I have plugged the tax benefits of Roth IRAs. And in February 15’s post, I extolled the virtues of a non-deductible IRA when a deduction is unavailable. Today I amalgamate them. What if you want to convert a non-deductible IRA to a Roth IRA?

First, of course, you have to determine if you’re allowed to. February 10’s post pointed out that in 2009, you can do this only if your Adjusted Gross Income is $100,000 or less. But in 2010 and thereafter, that requirement disappears. Poof! It’s gone! And of course you generally have to pay income tax on the amount converted.

But if you’ve made non-deductible contributions to your traditional IRA, you don’t have to pay income tax on that portion. You paid tax going in, so you don’t have to pay it again. No double tax. Here’s an example. Let’s say your only IRA is worth $80,000 and over the years your aggregate non-deductible contributions have totaled $10,000. In tax jargon, $10,000 is your tax basis in the IRA. (You can find this number on your most recently filed Form 8606.) If you convert the entire IRA to a Roth IRA, you’ll have to pay tax on $70,000 (= $80,000 - $10,000).

But what if you convert only a portion of your IRA to a Roth IRA, e.g., because you can’t afford to pay tax on the whole thing? Then you recover a pro-rata portion of your tax basis. For example, if you convert $20,000 of your $80,000 IRA to a Roth IRA, that’s 25% of the total. So you recover $2,500 of your $10,000 tax basis, and pay tax on $17,500 (=$20,000 - $2,500). You then have $7,500 of basis left in your traditional IRA to recover tax-free in later years.

What if you’ve got more than one traditional IRA? In figuring the portion that’s tax-free, the IRS makes you aggregate all your traditional IRAs (but not your employer plans or Roth IRAs) and all your non-deductible contributions. So it doesn’t help to try to isolate your non-deductible contributions in one small IRA. The IRS is on to your little tricks!

But tomorrow I’ll describe a little trick that can work. Meet you back here about the same time tomorrow.