How Much Tax Do You Pay on a Roth Conversion?

A Roth conversion involves moving funds from a traditional individual retirement account (IRA) or 401(k) into a Roth IRA. This strategic financial move can offer future tax-free withdrawals in retirement. However, converting pre-tax money to a Roth account triggers a taxable event in the year the conversion occurs. Understanding the tax implications is important for individuals considering this option, as the amount converted can impact a person’s current tax liability.

Identifying Taxable Amounts

To undertake a Roth conversion, distinguish between pre-tax and after-tax contributions within your traditional IRA or 401(k), because only the pre-tax portion is subject to income tax. Pre-tax contributions are those for which you received a tax deduction or employer contributions that were never taxed. All earnings accumulated within the account, whether from pre-tax or after-tax contributions, are also considered pre-tax money until converted.

After-tax contributions, also known as your “basis,” are amounts you contributed to a traditional IRA for which you did not receive a tax deduction. Since these funds have already been taxed, they are not subject to income tax again when converted to a Roth IRA. Tracking your basis determines the non-taxable portion of your conversion. This tracking is done through IRS Form 8606, “Nondeductible IRAs.”

The “pro-rata rule” applies if you hold both pre-tax and after-tax money across all your traditional IRAs. This rule mandates that any conversion must be treated as coming proportionally from both your taxable and non-taxable funds. For example, if your total traditional IRA balance is $100,000, comprising $90,000 of pre-tax money and $10,000 of after-tax money (a 90% pre-tax, 10% after-tax ratio), a $20,000 conversion would be considered 90% pre-tax ($18,000) and 10% after-tax ($2,000). In this instance, only the $18,000 pre-tax portion would be added to your taxable income.

Calculating Your Tax Liability

The taxable portion of a Roth conversion is treated as ordinary income in the year the conversion occurs. This means the converted amount is added to all your other income sources for the year, such as wages, business income, or other investment gains. Consequently, this additional income can push you into a higher federal income tax bracket. For instance, if your income prior to conversion places you in the 22% tax bracket, and the conversion amount pushes you into the 24% bracket, a portion of the converted funds would be taxed at that higher rate.

Beyond the direct impact on your income tax bracket, a Roth conversion can influence your Adjusted Gross Income (AGI). An increased AGI may affect your eligibility for various tax credits, deductions, and the cost of certain healthcare premiums. For example, higher AGI can lead to increased Medicare Part B and Part D premiums, or it might reduce the amount of certain itemized deductions you can claim. Consider these broader financial implications when planning a conversion.

To estimate your tax liability, first determine the taxable amount using the pro-rata rule. Then, add this taxable amount to your projected ordinary income for the year. By referencing the current federal income tax brackets, you can calculate the marginal tax rate that will apply to the converted funds. For example, if a single filer has $50,000 in taxable income and converts an additional $20,000, bringing their total to $70,000, a portion of that $20,000 would be taxed at their marginal rate, which could be 22% or higher depending on the specific bracket thresholds for the tax year.

State income taxes can apply to your Roth conversion, depending on your state of residence. Most states that levy an income tax follow federal guidelines regarding what constitutes taxable income. Therefore, if your state has an income tax, the taxable portion of your Roth conversion will be subject to state taxation.

Tax Reporting for Conversions

When you complete a Roth conversion, your financial institution will issue Form 1099-R, “Distributions From Pensions, Annuity, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.,” by January 31 of the following year. This form will report the gross amount of your conversion in Box 1 and may show a zero in Box 2a, “Taxable amount,” because the financial institution may not know your non-deductible basis. Box 7, “Distribution code,” will show code “2” for early distribution, exception applies, or “G” for direct rollover and direct trustee-to-trustee transfer.

Completing IRS Form 8606, “Nondeductible IRAs,” is important for accurately reporting your Roth conversion. This form tracks your basis in traditional IRAs, which are your after-tax contributions. You will report your total basis in all traditional IRAs on this form, as well as the total value of all your traditional IRAs at year-end. Form 8606 then helps calculate the taxable portion of your Roth conversion for the year, applying the pro-rata rule.

Part II of Form 8606 is dedicated to Roth conversions. You will report the amount converted from traditional IRAs to Roth IRAs on Line 18. The form guides you to determine the taxable amount of your conversion, taking into account your total non-deductible contributions across all your traditional IRAs. This process ensures that only the pre-tax portion of your conversion is subject to income tax.

Once Form 8606 is completed, the calculated taxable amount from your Roth conversion is reported on your main tax return, on Line 4b of Form 1040, “IRA distributions.” Include both Form 1099-R and Form 8606 when filing your tax return. These forms can be obtained directly from the IRS website or through various tax preparation software programs.