An IRA provides a way to defer taxes on your investments. Within limits, you can deduct your traditional IRA contributions, but this creates taxable income when you later make withdrawals. The money you contribute to a Roth IRA is post-tax -- meaning you receive no deduction -- but you may withdraw your money tax-free by observing the Internal Revenue Service’s distribution rules. The portion of your traditional IRA stemming from deductible contributions creates taxable income when you convert to a Roth IRA.
You might be motivated to convert to a Roth IRA for several reasons. The tax-free withdrawals after age 59 1/2 put more money in your pocket when you might otherwise have lower or no other income, save Social Security. Another reason to convert is to avoid the required minimum distributions at age 70 1/2 that traditional IRAs require. A third reason is that you can withdraw your Roth contributions at any time without penalty or taxes, although you lose the tax-free earning power of the withdrawn money. Finally, if your income exceeds Roth limits, you can always contribute to a traditional IRA — which allows contributions without regard to income — and then convert it to a Roth. Still, you must hold a Roth IRA for at least five years and be no younger than age 59 1/2 to avoid taxes and penalties on withdrawn earnings.
Traditional IRA Deduction Limits
The maximum you can contribute to an IRA in 2013 is $5,500, or $6,500 if you are 50 or older. You can deduct your contribution unless your modified adjusted gross income, or MAGI, exceeds the deduction limits. The limits begin to curtail your deductions when your income exceeds a lower threshold. Your deduction percentage decreases with increasing income until you hit a second threshold, at which point you receive no deduction. The 2013 thresholds for single filers are $59,000 and $69,000. For married couples, the MAGI thresholds are $95,000 and $115,000.
You can still contribute to your traditional IRA even if your MAGI exceeds the IRS income limits -- however, the IRS will partially or fully disallow your deduction, depending on your MAGI. Your traditional IRA’s basis is the total amount of all your non-deductible contributions. When you convert a traditional IRA into a Roth IRA, this basis is not taxable income.
Taxable Income on a Complete Roth Conversion
You need to figure the taxable income that you create when you convert your traditional IRA to a Roth IRA. This task is simple if you convert the entire traditional IRA -- the taxable income is equal to the total conversion amount minus the basis. For example, if your traditional IRA balance is $100,000 of which $13,000 represents non-deductible contributions, you create $87,000 in ordinary taxable income through the Roth IRA conversion. Of course, your actual tax bill for the year depends on your total income, deductions and credits. Traditional IRAs require minimum distributions once you attain age 70½. You cannot convert any required minimum distributions for the tax year.
Taxable Income on a Partial Roth Conversion
Although you can convert only part of your traditional IRA to a Roth IRA, you cannot specify a partial rollover of only your non-deductible contributions. Rather, the IRS requires you to prorate your non-deductible contributions as a percentage of your total traditional IRA money on Form 8606.
Calculating and Reporting a Roth Conversion
The IRS requires you to calculate and report Roth conversions on one or more forms, depending on your circumstances. Use Form 1040 or one of its variants if you are converting a traditional IRA that contains no non-deductible contributions. If an employer plan covers you or your spouse, you must first fill out Worksheet 1-2, "Figuring Your Reduced IRA Deduction for Year 20XX" in Publication 590. Use Form 8606 if your traditional IRA contains non-deductible contributions. If you made any of your non-deductible contributions for the filing tax year, also use Worksheet 1-5, "Figuring the Taxable Part of Your IRA Distribution" in Publication 590.
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.