Taxes on IRA Earnings at Conversion

by Herb Kirchhoff

The federal laws governing individual retirement accounts (IRA) allow you to convert your retirement savings from a traditional tax-deferred IRA into a tax-free Roth IRA without incurring an early-withdrawal penalty on top of income taxes on the transaction. The Internal Revenue Service (IRS) in 2010 removed a $100,000 income limit that kept higher-income taxpayers from making Roth conversions.

Tax Bite

When you take a distribution from your traditional tax-deferred IRA for conversion to a tax-free Roth IRA, you will owe income tax on the deductible IRA contributions you originally made. You also will owe income tax on any earnings from those contributions. If you convert all the funds from your distribution into a Roth IRA, you will avoid the 10 percent tax penalty on early distributions. If you keep any of the distribution for yourself, such as for paying the taxes on your transaction, you will owe the 10 percent early-distribution tax penalty plus income taxes on the amount you kept.

No Difference

In IRA conversions, the IRS makes no tax distinction between the money you contributed to your traditional IRA and the money earned on your contributions while they were in the traditional IRA. For accounting purposes, the IRS counts IRA distributions against your direct contributions first, then against any rollover contributions, and last, against earnings. But your income tax is figured on the total amount of your conversion distribution, whether or not it included earnings.


You can accomplish the conversion as an IRA rollover or by a direct trustee-to-trustee transfer. The process is simple if all your contributions were deductible. You designate the IRA account and amount to be converted. Your fiduciary completes the transaction and sends you a 1099 form with the details and taxable amounts. You add the conversion distribution to your other taxable income for the year when computing your adjusted gross income.

Possible Complication

If you have multiple traditional IRAs and made nondeductible contributions to any of them, the conversion process gets complicated. Nondeductible IRA contributions aren't taxable, so you must subtract those from your distribution. But with nondeductible contributions in the picture, you can't pick and choose which of your IRAs to deduct from. You must withdraw a proportional amount from each IRA to make up your conversion distribution. If you had a traditional IRA with $6,000 and another with $3,000, had made a nondeductible contribution to either one, and wanted to convert $3,000 to a Roth IRA, you couldn't simply convert the $3,000 account. Instead, you would have to draw $2,000 from the larger account and $1,000 from the smaller account to make up the conversion distribution.

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