Roth IRA conversion taxes may be trickier than you expect. Here's what to know before filing — or converting funds in 2023
- If you completed a Roth individual retirement account conversion in 2022, your tax return may be complicated, experts say.
- When figuring out your tax bill, you need to use the "pro-rata rule," which factors your pretax IRA funds into the calculation.
- Experts say it's important to project your total income before converting funds in 2023.
If you made a Roth individual retirement account conversion in 2022, you may have a more complicated tax return this season, experts say.
The strategy, which transfers pretax or non-deductible IRA funds to a Roth IRA for future tax-free growth, tends to be more popular during a stock market downturn because you can convert more assets at a lower dollar amount. While the trade-off is upfront taxes, you may have less income by converting lower-value investments.
"You get more bang for your buck," said Jim Guarino, a certified financial planner and managing director at Baker Newman Noyes in Woburn, Massachusetts. He is also a certified public accountant.
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If you completed a Roth conversion in 2022, you'll receive Form 1099-R from your custodian, which includes the distribution from your IRA, Guarino said.
You'll need to report the transfer on Form 8606 to tell the IRS which portion of your Roth conversion is taxable, he said. However, when there's a mix of pretax and non-deductible IRA contributions over time, the calculation may be trickier than you expect. (You may have non-deductible contributions in your pretax IRA if you don't qualify for the full or partial tax break due to income and workplace retirement plan participation.)
"I see a lot of people making a mistake here," Guarino said. The reason is the so-called "pro-rata rule" which requires you to factor your aggregate pretax IRA funds into the calculation.
How the pro-rata rule works
JoAnn May, a CFP and CPA with Forest Asset Management in Berwyn, Illinois, said the pro-rata rule is the equivalent of adding cream to your coffee then finding you can't remove the cream once it's poured.
"That's exactly what happens when you mix pretax and non-deductible IRAs," she said, meaning you can't simply convert the after-tax portion.
For example, let's say you have a pretax IRA of $20,000 and you made a non-deductible IRA contribution of $6,000 in 2022.
If you converted the entire $26,000 balance, you would divide $6,000 by $26,000 to calculate the tax-free portion. This means roughly 23% or about $6,000 is tax-free and $20,000 is taxable.
Alternatively, let's say you have $1 million across a few IRAs and $100,000, or 10% of the total, is non-deductible contributions. If you converted $30,000, only $3,000 would be non-taxable and $27,000 would be taxable.
Of course, the bigger your pretax IRA balance, the higher percentage of the conversion will be taxable, May said. Alternatively, a larger non-deductible or Roth IRA balance reduces the percentage.
But here's the kicker: Taxpayers also use the Form 8606 to report non-deductible IRA contributions every year to establish "basis" or your after-tax balance.
However, after several years, it's easy to lose track of basis, even in professional tax software, warned May. "It's a big problem," she said. "If you miss it, then you're basically paying tax on the same money twice."
Timing conversions to avoid an 'unnecessary' tax bump
With the S&P 500 still down about 14% over the past 12 months as of Jan. 19, you may be eyeing a Roth conversion. But tax experts say you need to know your 2023 income to know the tax consequences, which may be difficult early in the year.
"I recommend waiting until the end of the year," said Tommy Lucas, a CFP and enrolled agent at Moisand Fitzgerald Tamayo in Orlando, Florida, noting that income can change from factors like selling a home or year-end mutual fund distributions.
Typically, he aims to "fill up a lower tax bracket," without bumping someone into the next one with Roth conversion income.
For example, if a client is in the 12% bracket, Lucas may limit the conversion to avoid spilling into the 22% tier. Otherwise, they'll pay more on the taxable income in that higher bracket.
"The last thing we want to do is throw someone into an unnecessary tax bracket," he said. And boosting income may have other consequences, such as reduced eligibility for certain tax breaks or higher Medicare Part B and D premiums.
Guarino from Baker Newman Noyes also crunches the numbers before making Roth conversion decisions, noting that he's "essentially performing the Form 8606 calculation during the year" to know how much of the Roth conversion will be taxable income.