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Moving taxed funds from an IRA to a Roth IRA

A reader asks if his taxed retirement contributions will be taxed again.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: I have a traditional IRA with assets valued at about $200,000 in it, $37,000 of which consists of non-deductible contributions I've made. My income is low enough so that I qualify to do a Roth conversion. So can I convert the $37,000 into a Roth IRA tax free? -Eberhard, Clemmons, North Carolina

Answer: Ah, it would be great if you could just pull $37,000 of non-deductible contributions from your traditional IRA and move it to a Roth without paying any tax on the conversion.

And in a way it makes sense, doesn't it? After all, you've already paid tax on those non-deductible contributions, which means Uncle Sam has already skimmed his share of that money.

Well, our government doesn't see it that way. When you convert money from a traditional IRA to a Roth, it doesn't matter whether you consider the money you're transferring non-deductible contributions, deductible contributions or earnings. For that matter, if you have several IRAs, as many people do, it doesn't even matter which IRA you're pulling the money from.

As far the feds are concerned, you've got to look at your traditional (i.e., non-Roth) IRA funds as one big pie that includes all of your accounts and all of the different types of money (deductible, non-deductible and earnings) in those accounts.

And when you convert a piece of that traditional IRA pie to a Roth, that slice is, in effect, considered a miniature version of the total pie, an exact replica only smaller. Which means that the proportions of deductible, non-deductible and earnings money you have in your IRA pie overall are what you have in any slice of that pie you want to convert to a Roth.

So let's apply this concept to your situation.

You have $200,000 in your traditional IRA. (I'll assume you have one IRA account, but it wouldn't matter if that $200,000 was spread among several non-Roth IRA accounts. You would have to consider them all for a total pool of $200,000.)

As far as income taxes are concerned, $37,000 of that pool has already been taxed (the non-deductible contributions) and $163,000 hasn't been taxed yet (your deductible contributions, plus all the investment earnings in the account). So 81.5 percent of your IRA money is taxable ($163,000 divided by $200,000) and 18.5 percent isn't ($37,000 divided by $200,000).

Those same percentages must apply to any money from your regular IRA pool that you want to convert to the Roth. If you want to convert $37,000, then $30,155 is taxable (81.5 percent of $37,000) and $6,845 is not (18.5 percent of $37,000).

So if you're in the 25 percent tax bracket, you would owe tax of $7,536 on the conversion, or 25 percent of $30,155. (By the way, you'll want to pay that tax bill with money from a savings account or assets, not from the IRA money itself. For an explanation of why doing so enhances the value of a Roth, click here.)

Now, since IRAs and Roth IRAs are essentially creatures of Congress and subject to tax laws and regulations, there are a number of complications that time, space and my respect for humans' tolerance for absorbing boring details prevent me from going into here.

For example, to do a conversion now or over the next few years, your modified adjusted gross income can't exceed $100,000. The taxable amount of the conversion does not count toward that limit. The taxable amount of the conversion does count as taxable income, however, for determining your tax bracket. Which means that adding the taxable conversion amount to your other income could push you into a higher tax bracket. So, for example, if the $30,155 taxable amount of your conversion pushed you from the 25 percent to the 28 percent tax bracket, the tax you would owe on the conversion would be $8,443 instead of the $7,536 in the example above.

For all the information you'll ever need on virtually all aspects of Roth's from conversions to taxes to the pros and cons of converting I suggest you take a look at the Roth IRA guide at Fairmark.com.

That said, I do want to point out a few other things I think you as well as anyone else considering a Roth, whether opening one outright or converting should know.

Last year Congress passed a law last year that starting in 2010 will eliminate the $100,000 income ceiling for conversions. So if you want to convert more of your traditional IRA funds to a Roth later on and you can't because your income is too high, you can at least be sure that you'll be able to convert starting in 2010 (unless Congress changes the ground rules again in the meantime).

And although that provision eliminating the $100,000 limit in 2010 doesn't explicitly change the income eligibility requirement for contributing to a Roth each year for those requirements, click here it does give you a way to make an end run around those income requirements.

Basically, all you do is contribute to a non-deductible IRA (which anyone can do as long as he or she has earned income) and then convert the non-deductible IRA to a Roth. (And, yes, the "slice of the pie" rule that I outlined above would also apply to figuring the tax on that conversion as well.) I can certainly understand if at this point people are saying to themselves, "My word (or perhaps a stronger expletive), with all these rules and details is it really worthwhile to even consider a conversion?"

I sympathize. You would think our legislators down in D.C. would want to make it easier for us to save for retirement instead of creating a ridiculously unwieldy system you practically have to be a CPA to understand.

Nonetheless, I still think it's worth sorting through this stuff and doing whatever you must so that one way or another you get some bucks into a Roth IRA.

For one thing, as I pointed out in an earlier column, a Roth has some distinct advantages that can help leverage your retirement savings and fatten your nest egg. And as I pointed out in a separate column, adding a Roth to your retirement investment portfolio allows you to practice what I like to call "tax diversification," which is a fancy way of saying it allows you to hedge your tax exposure and gives you more wiggle room to increase your after-tax income in retirement.

So even though you can't pull off that Roth conversion without laying out some money for taxes, I still think you ought to pursue it. Come retirement time it will be nice to have a pot of money you can draw on without having to share with Uncle Sam.


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