If you converted a Roth individual retirement account in 2022, you may have a more complicated tax return this season, experts say.
The strategy, which transfers pretax or non-deductible IRA funds into a Roth IRA for future tax-free growth, is usually more popular during a stock market downturn because you can convert more assets for a lower dollar amount. While the trade-off is prepayments, you can have less income by switching lower-value investments.
“You get more bang for your buck,” says Jim Guarino, a certified financial planner and general manager at Baker Newman Noyes in Woburn, Massachusetts. He is also a chartered accountant.
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If you complete a Roth conversion in 2022, you’ll receive Form 1099-R from your custodian, which includes the distribution of your IRA, Guarino said.
You must report the transfer on Form 8606 to tell the IRS what portion of your Roth conversion is taxable, he said. However, when there’s a combination of pretax and non-deductible IRA contributions over time, the calculation can be trickier than you expect. (You may have non-deductible contributions to your pre-tax IRA if you don’t qualify for the full or partial tax credit as a result of participating in the income and retirement plan.)
“I see a lot of people making a mistake here,” Guarino said. The reason is the so-called “pro-rata rule,” which requires you to include your total 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, Ill., said the pro-rata rule is the equivalent of adding cream to your coffee and then discovering you can’t remove the cream once it’s set. poured in.
“That’s exactly what happens when you mix pre-tax and non-deductible IRAs,” she said, meaning you can’t just roll over the after-tax portion.
Let’s say you have a pre-tax IRA of $20,000 and you made a $6,000 non-deductible IRA contribution in 2022.
If you converted the entire balance of $26,000, 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, let’s say you have $1 million over a few IRAs and $100,000, or 10% of the total, are non-deductible contributions. If you converted $30,000, only $3,000 would be non-taxable and $27,000 would be taxable.
Of course, the larger your pre-tax IRA balance, the higher the percentage of the conversion will be taxed, May said. Alternatively, a larger non-deductible or Roth IRA balance lowers the percentage.
But here’s the kicker: Taxpayers also use Form 8606 to report non-deductible IRA contributions each year to determine “basis,” or your after-tax balance.
After a few years, however, it’s easy to lose track of the basics, even in professional tax software, May warned. “It’s a big deal,” she said. “If you miss it, you’re actually paying tax twice on the same money.”
Timing conversions to avoid an ‘unnecessary’ tax increase
With the S&P 500 still down about 14% over the past 12 months as of January 19, you may see a Roth conversion. But tax experts say you need to know your 2023 income to know the tax consequences, which can be tricky early in the year.
“I recommend waiting until the end of the year,” said Tommy Lucas, a CFP and enrolled agent with Moisand Fitzgerald Tamayo in Orlando, Florida, noting that income can change due to factors such as home sales or payments at the end of the year.
Typically, he’s trying to “fill up a lower tax bracket,” without bumping anyone into the next with Roth conversion earnings.
For example, if a customer is in the 12% tier, Lucas can limit conversion to avoid falling into the 22% tier. Otherwise, they pay more on the taxable income in that higher bracket.
“The last thing we want is to throw someone into an unnecessary tax bracket,” he said. And increasing income can have other consequences, such as reduced eligibility for certain tax breaks or higher Medicare Part B and D premiums.
Baker Newman Noyes’s Guarino also crunches the numbers before making Roth conversion decisions, noting that he “essentially runs the Form 8606 calculation during the year” to know how much of the Roth conversion will be taxable income.