The Internal Revenue Service allows you to convert money from a traditional IRA to a Roth IRA through a rollover. Converting from the tax-deferred traditional IRA to the after-tax Roth IRA mostly benefits people who expect to pay a higher tax rate in retirement than they currently are, or people who want to avoid having to take minimum required distributions.
Although it is not utilized very often, the IRS permits taxpayers to make nondeductible contributions to their traditional IRA. When you make a nondeductible contribution to a traditional IRA, you do not deduct it from your income taxes. The money then grows tax-free in the account, and when it comes time to take a distribution, the portion of the withdrawal that comes from the nondeductible contributions comes out tax-free.
Effects of Nondeductible Contributions on Rollovers
Typically, the entire amount of your traditional IRA to Roth IRA conversion is taxable because the entire amount is tax-deferred, and you are converting it to a Roth IRA, which is an after-tax account. When the traditional IRA that you are converting contains nondeductible contributions, this is no longer the case because nondeductible contributions are after-tax dollars. When you convert after-tax dollars in a traditional IRA to a Roth IRA, those dollars do not count as taxable income.
Figuring the Taxable Portion
When you rollover money from a traditional IRA containing nondeductible contributions, you have to calculate the taxable portion of the rollover. To do so, you have to calculate the percentage of your traditional IRA made up of nondeductible contributions. For example, if you have $80,000 in a traditional IRA with $20,000 of nondeductible contributions, than means that 25 percent of the account comes from nondeductible contributions. When you perform a conversion, 25 percent of your conversion amount comes from the nondeductible contributions, and is therefore non-taxable.
When you file your taxes for the year that you convert money from a traditional IRA to a Roth IRA, you have to use Form 8606 to document the taxable portion of the withdrawal. After completing Form 8606, use Form 1040 to report your taxable and nontaxable portions. On line 15a, report the nontaxable portion, if any, and on line 15b, report the taxable portion. Although the IRS requires you to include the nontaxable portion on the Form 1040, it does not affect your tax liability for the year.
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