Raise Your Hand If You Know How Much You'll Need in Taxes
Not so fast!
So you’ve decided to convert your Non-Deductible IRA to a Roth IRA despite our warnings. How much in taxes will you owe as a result of converting?
Surprisingly, if you own both Deductible and Non-Deductible IRAs and you convert only the Non-Deductible IRA, you won’t know until next year. That’s because the IRS considers conversions to consist proportionately of each type of IRA you own.
Let’s say you have $100,000 in IRAs — $40,000 in after-tax contributions and $60,000 in pre-tax contributions. To determine how much of the conversion you’d have to pay taxes on, you divide the pretax amount by the account’s total ($60,000/$100,000 = .60). Thus, you would have to pay taxes on 60% of any money you convert. So if you decide to convert $40,000, you’d pay taxes on $24,000. At an ordinary tax rate of 28%, that’s $6,720.
But this calculation is based on the year-end value of your IRAs — including the money you converted — not their value on the day you converted. So if your account increases in value by year-end (or if you rollover a pre-tax 401(k) into an IRA) you might pay more in taxes than you expect.
This is just another example of the absurd intricacies when converting to a Roth IRA and why converting may not be in your best interest.