By Jim Blankenship, originally published at Getting Your Financial Ducks In A Row.
Photo credit: jb
We’ve discussed here in the past about how it is a perfectly legal maneuver to make a non-deductible contribution to a traditional IRA and then at some point later convert the same contribution to your Roth IRA (see Is it Really Allowed? for more). If you have no other IRA accounts, this conversion to Roth can be a tax-free event, especially if there has been no growth or gains on the investments in the account.
However (and there’s always a however in life) I recently came across a situation that was sent to me by a reader that alters the equation. The reader wanted to do just such a Roth conversion, but he also wanted to rollover some money from his 401(k) plan into an IRA. The question is in the timing – understandably, if he does the conversion from the traditional IRA to the Roth IRA, there will be no tax on the conversion, since he doesn’t have any other IRA accounts.
As we know, when taking distributions from an IRA (such as for a conversion) the taxability of the distribution depends upon the total amount of money in all IRAs, and how much is pre-tax versus how much is post-tax.
Here’s the example: Joe has an IRA with deductible contributions of $4,000 and subsequent growth of $1,000. He is no longer eligible for deductible contributions to his account, and he also is not eligible for contributions to a Roth IRA, both due to his income level. He wants to make a non-deductible contribution of $5,000 to the IRA and then later convert the money to his Roth IRA. When he does the conversion, his $5,000 conversion will be partly taxed – since half of his total IRA is non-deductible contributions, every dollar he converts is 50% taxed, and 50% tax-free.
So, if Joe did the same thing except that he starts out without any traditional IRA at all, and when he converts $5,000 from his traditional IRA to the Roth IRA, the entire amount of the conversion will be tax-free. Maybe.
