Tax planning and compliance for investors
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Kaye A. Thomas
Updated January 21, 2008
Answers to questions about the consequences of converting a traditional IRA to a Roth IRA.
Unlike rollovers, a conversion from a traditional IRA to a Roth IRA is taxable. All of the income is treated as ordinary income, even if some or all of the growth in value of your traditional IRA was from an increase in value of stocks or mutual funds.
If all of your contributions to all of your traditional IRAs have been deductible, then the full amount of your rollover is taxable.
Q: Can I report part of this amount as capital gain?
A: No, it's all ordinary income, even if some or all of the income produced by your traditional IRA was from capital gains.
Q: If I convert assets other than cash (such as stock or mutual fund shares) from my traditional IRA to a Roth IRA, what is the amount of the conversion?
A: The amount of the conversion is the amount of cash plus the fair market value of the property, as of the date of the conversion. For this purpose, the date of the conversion is when assets were taken from the traditional account, not when they went into the Roth IRA, if that's a different date.
If you've made nondeductible contributions to one or more regular IRAs, then the conversion will be at least partly nontaxable.
Q: Can I convert just the nontaxable part, and leave the taxable part in my regular IRA?
A: No, your conversion distribution will be treated as partly taxable and partly nontaxable, even if you try to roll only the nontaxable part.
Q: What if I have more than one traditional IRA? Can I convert one but not the other?
A: Yes, but when you determine how much of your conversion distribution is taxable, you're required to treat all your traditional IRAs as if they were one big IRA, so you don't get any advantage if you take the distribution out of the IRA that has the most nondeductible contributions.
Q: How do I determine how much of my distribution is nontaxable if I made nondeductible contributions to one or more of my traditional IRAs?
A: If you convert the entire amount of all traditional IRAs you own, then the non-taxable part of your rollover distribution is simply the total amount of nondeductible contributions you made to all of those IRAs, less the amount of nontaxable distributions you received in the past. If you convert only part of your traditional IRA, or if you have more than one traditional IRA and don't convert all of them, then the nontaxable part of your conversion distribution will be determined by a formula where the nontaxable percentage is the amount of your total nondeductible contributions (less any nontaxable distributions you previously received) divided by the total balance of all of your traditional IRAs.
The amount of tax you pay depends mainly on your tax bracket. But you need to remember that your tax bracket can change if your taxable income increases. For example, if you are near the top of the 15% tax bracket before you make a conversion to a Roth IRA, you may find that most of the income from the conversion is taxed at the 25% rate. For more on this subject, see How Much Conversion Tax.
Normally if you take a taxable distribution from an IRA before age 59½ you pay a 10% early distribution penalty unless you can fit within various specific exceptions. A special exception has been created for conversions to Roth IRAs, so you won't pay a penalty on your conversion even if you're under age 59½.
Most people don't have to pay estimated tax if all (or nearly all) of their income is from compensation that's subject to withholding. But there won't be any withholding on the income you report when you convert a traditional IRA to a Roth. It's possible you'll have to pay a penalty if you don't make estimated tax payments to cover some or all of the tax you'll owe on a conversion from a regular IRA to a Roth IRA.
Depending on your circumstances, you may be able to avoid penalties without making any estimated tax payments.
Example: In 2008 you earn $60,000 and your withholding is enough to cover the full amount of your tax. In 2009 you earn $68,000 and you also convert a traditional IRA to a Roth, reporting an additional $30,000 of income. Although you owe a substantial amount of tax on this additional income, you fall within an exception to the requirement to make estimated tax payments. The reason is that your withholding for 2009 is at least equal to the amount of tax you paid for 2008.
It's a good idea to become familiar with the rules for estimated payments if you report income from a conversion. These rules are discussed in our Guide to Estimated Taxes.
There are some special rules, explained elsewhere in this guide, for distributions from a Roth IRA following a conversion.
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