Converting money from a pretax retirement account to a Roth IRA allows you to pay the taxes when you make the conversion and then take tax-free distributions at retirement. Whether you want to convert all of your retirement assets or just a portion of one of your retirement plans, the choice is yours. By choosing to convert only a portion of your assets each year, you can space out the tax impact over several years.
You can choose which assets within a specified plan that you want to move convert to a Roth IRA. For example, if you anticipate your international growth mutual fund increasing rapidly while you expect your other assets in the retirement account grow more slowly, you could choose to convert just the money in the international growth fund to a Roth IRA and leave the remaining assets in the pretax retirement account. However, the basis included in the conversions depends on the total basis in the account. Your basis in a retirement account is the amount of after-tax contributions, also called nondeductible contributions, you've made to the account.
Basis of Conversion
If you have a basis in one of your pretax retirement accounts, it reduces the amount of the conversion included in your income taxes. You have a basis in your account if you made nondeductible contributions to the pretax retirement account. However, the basis must be spread among the assets you choose to convert and those you leave in the pretax account. For example, if you have $50,000 in your traditional IRAs and a $20,000 basis, 40 percent of your account is basis. If you convert $20,000, only $8,000 of the basis is used, so you must include $12,000 as taxable income.
If you have multiple types of pretax retirement plans, such as a traditional IRA, 401(k) plan and 403(b) plan, the basis for each of the plans is used only for the conversion of that particular plan. For example, if you have a traditional IRA with a $10,000 basis and a 401(k) plan with no basis, none of the basis would be used if you converted your 401(k) plan to a Roth IRA. If you converted all of your traditional IRA but none of your 401(k) plan instead, the entire $10,000 basis would be used.
When you convert all or a portion of your retirement plans to a Roth IRA, you have to share the news with Uncle Sam on your tax return. First, you have to calculate the taxable portion of the distribution using Form 8606. Next, report the entire amount of the conversion as a nontaxable IRA distribution or pension and annuity distribution. Then, report the taxable portion of the conversion as a taxable IRA or pension and annuity distribution.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."