Reader Question: This question may help a lot of people deciding on Roth IRA conversions. With a traditional non-deductible IRA what, if any, taxes are due if you convert it to a Roth IRA? Can you give an example? My understanding is that you don’t have to pay taxes on the amount contributed…only on the ‘growth’ or profit portion. Is there a ‘formula’ that the IRS applies to this? R.R.
Answer: With a traditional non-deductible IRA, you’ve already paid income taxes on your contributions so that portion is not subject to income taxes if you decide to convert to a Roth IRA. If you have a gain or profit on your investments, that portion is treated as ordinary income in the year of conversion. For example, let’s say you’ve invested $10,000 into a traditional non-deductible IRA that is worth $12,000. If you converted to a Roth IRA this year, you’d have to report the $2,000 of gain on your 2012 income tax return. If your $10,000 investment was worth $9,000, there would not be a reportable gain.
Here’s where it gets tricky. Assume that in addition to your $12,000 traditional non-deductible IRA (which has a $2,000 gain), you also have a traditional (fully deductible) IRA worth $20,000. When you convert your traditional non-deductible IRA you must ‘aggregate’ both IRAs for the purpose of determining the reportable gain. Now you’d have $32,000 of total IRA investments with $22,000 that has not been taxed… or 69%. Now when you convert your $12,000 non-deductible IRA to a Roth, you’ll have to report 69% or approximately $8,280 as taxable income on your 2012 tax return. You’ll also be responsible for keeping up with taxes paid across these accounts for future reference.
There might be a better way. Recently, in working with a client who wanted to convert a non-deductible IRA to a Roth but also had a substantial deductible IRA, we determined that his company 401k plan allowed him to roll-up a traditional IRA into the plan. We rolled his fully taxable traditional IRA into his 401k plan in one calendar year, then converted his non-deductible IRA to a Roth IRA in January of the following year and voila!…avoided the higher taxes! Now, each year, we make a maximum contribution to a non-deductible IRA and immediately convert it to a Roth IRA. By doing this we avoid the income limitation associated with a direct investment in a Roth IRA.
Reader Question: My daughter is 31 and has a job working for a non-profit making $6,000 a year. In two years it will be permanent and she will make close to $85,000. My husband wants her to invest in a home for tax purposes. She is reluctant and feels she’s not ready yet. What do you recommend? How much savings are we looking at if she were to invest in a home. We are Baby Boomers and will be retiring at the end of the year. If she were to invest in a home, we would contribute to the mortgage payment. Z.P.
Answer: It is very generous of you to offer to help your daughter pay for a home and now is a great time to buy because prices are typically much lower than a couple of years ago and mortgage interest rates are at historical lows. With $85,000 of earned income, her mortgage interest deduction would add a nice tax benefit. However, buying, owning and maintaining a home is a huge responsibility and I’d recommend that your daughter wait until she feels she’s ready.