If you made a Roth Individual Retirement Account conversion in 2022, you could have a more complicated tax return this season, experts say.
The strategy, which transfers pre-tax 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 to a lower amount. Although the trade-off is up-front taxes, you may have less income by converting lower-value investments.
“You get more for your money,” said Jim Guarino, certified financial planner and general manager of Baker Newman Noyes in Woburn, Massachusetts. He is also a chartered accountant.
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If you made a Roth conversion in 2022, you’ll receive Form 1099-R from your custodian, which includes your IRA distribution, Guarino said.
You’ll need to report the transfer on Form 8606 to tell the IRS which part of your Roth conversion is taxable, he said. However, when there is a mix of pre-tax and non-deductible IRA contributions over time, the calculation can be trickier than expected. (You may have non-deductible contributions to your pre-tax IRA if you don’t qualify for full or partial tax relief due to your income and participation in a workplace retirement plan.)
“I see a lot of people making a mistake here,” Guarino said. The reason for this is the so-called “pro-rating rule” which requires you to factor your pre-tax IRA funds into the calculation.
How the pro rata rule works
JoAnn May, CFP and CPA at Forest Asset Management in Berwyn, Ill., said the proration rule is like adding cream to your coffee and then finding you can’t take the cream off once it is paid.
“That’s exactly what happens when you mix pre-tax and non-deductible IRAs,” she said, meaning you can’t just convert the after-tax portion.
For example, suppose you have a pre-tax IRA of $20,000 and you made a non-deductible IRA contribution of $6,000 in 2022.
If you convert the entire balance of $26,000, you will divide $6,000 by $26,000 to calculate the tax-free portion. That means about 23% or about $6,000 is non-taxable and $20,000 is taxable.
Alternatively, let’s say you have $1 million on a few IRAs and $100,000, or 10% of the total, are non-deductible contributions. If you convert $30,000, only $3,000 would be non-taxable and $27,000 would be taxable.
Of course, the larger your pre-tax IRA balance, the more taxable the conversion percentage will be, May said. Alternatively, a larger non-deductible or Roth IRA balance reduces the percentage.
But here’s the trick: Taxpayers also use Form 8606 to report non-deductible IRA contributions each year to establish the “base” or your after-tax balance.
However, after several years, it’s easy to lose track of the basis, even in professional tax software, May warned. “It’s a big deal,” she said. “If you miss it, you’re essentially paying twice the tax on the same money.”
Synchronize conversions to avoid an “unnecessary” tax increase
With the S&P500 still down about 14% in the past 12 months as of Jan. 1. 19, you may be considering a Roth conversion. But tax experts say you need to know your 2023 income to know the tax implications, which can be tricky early in the year.
“I recommend waiting until the end of the year,” said Tommy Lucas, CFP and registered agent at Moisand Fitzgerald Tamayo in Orlando, Florida, noting that income may change due to factors such as the sale of a home or year-end mutual fund distributions.
Generally, it aims to “fill in a lower tax bracket”, without moving someone into the next one with Roth conversion income.
For example, if a customer is in the 12% bracket, Lucas can limit the conversion to avoid spilling over into the 22% bracket. Otherwise, they will pay more on taxable income in that higher bracket.
“The last thing we want to do is throw someone into an unnecessary tax bracket,” he said. And increased income can have other consequences, such as reduced eligibility for certain tax breaks or higher Medicare Part B and D premiums.
Baker Newman Noyes’ Guarino also analyzes the numbers before making Roth conversion decisions, noting that he “essentially does the Form 8606 calculation during the year” to figure out how much of the Roth conversion will be taxable income.