Roth IRA Rules After Tax Conversion

by Mark Kennan

If you have made after-tax contributions to a tax-deferred retirement account, you can increase your retirement benefits by converting the money to a Roth IRA so you can take out the earnings as well as the contributions tax-free. However, you need to know how to figure the taxable portion of the conversion and how the Internal Revenue Service treats the converted funds.

Taxation of Conversions Containing Nondeductible Contributions

Sometimes, people put money into a tax-deferred account without claiming a tax deduction either by choice or by necessity. When converting money from a traditional account that contains nondeductible contribution, the IRS allows you to avoid paying income taxes on the after-tax contributions. When you convert the entire amount, simply figure the taxable portion by subtracting the nontaxable contributions from the account total. Therefore, if you convert a tax-deferred account with $100,000 in nondeductible contributions and a total value of $300,000, you would include $200,000 as taxable income.

Figuring a Partial Conversion

When you only convert a portion of your tax-deferred account, you cannot simply select the after-tax contributions to convert so that you can avoid any income taxes. Instead, you have to prorate your conversion based on the composition in your account. To do so, divide the nondeductible contributions by the account value, subtract the result from 1 to find the taxable portion and multiply the taxable portion by the converted amount. For example, if you convert $30,000 from an account of $300,000 with $100,000 in after-tax contributions, divide $100,000 by $300,000 to get 0.3333333, then subtract 0.3333333 from 1 to get 0.6666667. Next, multiply 0.6666667 by $30,000 to find that $20,000 is taxable.

Withdrawals After the Conversion

If you take an early withdrawal from your Roth IRA after your conversion, you need to know the ordering rules for how money comes out. First, you withdraw your regular contributions you made to the Roth IRA. These come out tax-free and penalty-free. After exhausting your contributions, your conversions come out in a first-in first-out order. Within each contribution, the taxable portion comes out first and is subject to the early-withdrawal penalty if five years have not elapsed since the conversion. Then the nontaxable amount of the conversion comes out tax-free and penalty-free. Finally, any earnings come out subject to taxes and the early withdrawal penalty.

Qualified Converted Roth IRA Withdrawals

In order to take out a qualified withdrawal of money converted to your Roth IRA, you have to wait at least five tax years from the date of the conversion. In addition, you must be either 59 1/2, permanently disabled or taking out up to $10,000 for a first-home purchase. If you have multiple conversions, the date that you can take qualified distributions will differ for each conversion.

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