How to report Roth IRA conversions on your taxes

If you do a Roth individual retirement account conversion in 2022, you could end up with a more complicated tax return this season, experts say.

A strategy that rolls over pre-tax or non-deductible IRA funds into a Roth IRA for future tax-free growth tends to be more popular during stock market downturns because you can convert more assets for fewer dollars. Although the trade-off is upfront taxes, you may get less income by converting lower-value investments.

“You get more for your money,” said Jim Guarino, a certified financial planner and managing director of Baker Newman Noyes in Woburn, Massachusetts. He is also a certified public accountant.

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If you complete a Roth conversion in 2022, you’ll receive a Form 1099-R from your custodian containing the distribution from the IRA, Guarino said.

To tell the IRS how much of your Roth conversion is taxable, you must report the rollover on Form 8606, he said. However, when there’s a mix of pre-tax and non-deductible IRA contributions over time, the calculation can be trickier than you might expect. (If you do not qualify for a full or partial tax break due to income and participation in a workplace retirement plan, there may be non-deductible contributions to an IRA before taxes.)

“I see a lot of people making mistakes here,” Guarino said. The reason is the so-called “pro-rata rule,” which requires you to consider your cumulative pre-tax IRA funds in the calculation.

How the pro-rata rule works

JoAnn May, a CFP and CPA with Forest Asset Management in Berwyn, Illinois, says the pro-rata rule is like adding cream to your coffee and then finding you can’t get the cream out after you pour it.

“That’s exactly what happens when you mix pre-tax and non-deductible IRAs,” he said, meaning you can’t just roll over the after-tax portion.

For example, let’s say you have a pre-tax IRA of $20,000 and you make a non-deductible IRA contribution of $6,000 in 2022.

If you rolled over the entire $26,000 balance, you would divide $6,000 by $26,000 to calculate the tax-free portion. This means that about 23%, or about $6,000, is tax-free and $20,000 is taxable.

Alternatively, suppose you have $1 million in several IRAs and $100,000, or 10% of the total, are nondeductible contributions. If you roll over $30,000, only $3,000 will be tax-free and $27,000 will be taxable.

Of course, the larger your pretax IRA balance, the higher a percentage of the conversion will be taxed, May said. Alternatively, a larger non-deductible or Roth IRA balance reduces the interest.

But here’s the gist of it: Taxpayers use Form 8606 to report nondeductible IRA contributions each year to build your “principal,” or after-tax, balance.

However, after a few years, even in professional tax software, it’s easy to lose track of the base, May warned. “It’s a big problem,” he said. “If you miss that, you’re paying tax twice on the same money.”

Changing the timing to avoid an “unnecessary” tax hit

With S&P 500 Still down about 14% over the last 12 months to January 19th, you’re waiting for a Roth conversion. But tax experts say you need to know your 2023 income to know the tax consequences, which can be tricky at the beginning of the year.

“I recommend waiting until the end of the year,” said Tommy Lucas, CFP and enrolled agent at Moisand Fitzgerald Tamayo in Orlando, Fla., noting that income can vary from factors such as selling a home or year-end mutual fund distributions.

Typically, it aims to “fill a lower tax bracket” without bumping someone into the next one with Roth conversion income.

For example, if a customer is in the 12% bracket, Lucas can limit the conversion to avoid falling to the 22% bracket. Otherwise, they will pay more than the taxable income in the higher bracket.

“The last thing we want to do is put someone on an unnecessary tax stamp,” he said. And increasing income can have other consequences, such as reduced eligibility for certain tax credits or higher Medicare Part B and D premiums.

Guarino of Baker Newman Noyes crunches the numbers before making Roth conversion decisions, noting that he “does the Form 8606 calculation throughout the year” to know how much a Roth conversion will be taxable.

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