Taxes on Roth IRA conversions
You pay taxes on traditional IRA and 401(k) savings when you withdraw the funds, while you pay taxes on Roth savings when you make your initial Roth contribution. Switching from tax-deferred to Roth savings involves paying taxes on the converted amount. This raises your overall tax rate for the year.
The tax brackets are set up so those with larger taxable incomes owe a larger percentage of their income tax to the government. You should strive to stay below the upper limit of your tax bracket if possible. If your Roth conversion pushes you into the next tax bracket, you'll give up a larger portion of your earnings.
The other factor that affects your tax bill is whether your tax-deferred savings have a basis. Basis means the money you've already paid taxes on. It's not that common, but if you've made non-deductible contributions to a tax-deferred retirement account and you later decide to convert some of that money to a Roth IRA, you won't have to pay taxes on your basis. Unfortunately, the IRS doesn't enable you to convert your entire basis, leaving your deductible contributions alone.
Calculating Taxes on Conversions
To calculate the percentage of your Roth conversion that's tax-free if you have some basis, you'd divide your total nondeductible contributions by the year-end value of all of your IRA accounts plus the value of all conversions and any distributions taken during the year.
Say you have $20,000 in a traditional IRA, and $5,000 is a non-deductible contribution. If you decide you'd like to convert $5,000 to a Roth IRA, you would divide your total non-deductible contributions ($5,000) by the total value of your IRA at year's end (the $15,000 remaining in the account after your conversion) plus the amount you're converting ($5,000). In this case, that adds up to $20,000.
Dividing your $5,000 in nondeductible contributions by $20,000 leaves you with 25%. So you wouldn't owe taxes on 25%, or $1,250, of your $5,000 conversion because that's part of your basis. You'd only owe taxes on the remaining $3,750.
Owing taxes on your Roth IRA conversion doesn't mean you'll receive a tax bill, though you could. If you qualify for enough tax deductions and credits, you may just end up with a smaller tax refund for the year. If you do owe the government, you will need a plan to pay for these funds.
