Here’s how to report Roth IRA conversions on your taxes

If you converted your retirement account to a Roth in 2022, you may have a more difficult tax return this year, experts say.

The strategy, which moves 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 it can change you get more property for less dollars. Even if the sale is pre-tax, your income may be lower by switching to a lower investment.

“You get more leverage,” says Jim Guarino, a certified financial planner and managing director at Baker Newman Noyes in Woburn, Massachusetts. He is also a certified public accountant.

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

You need to report the transfer on Form 8606 to tell the IRS what portion of your Roth conversion is taxable, he said. However, when there is a mix of pre-tax and non-deductible IRA contributions over time, the calculation can be more complicated than you might expect. (You may have non-deductible contributions to a pre-tax IRA if you do not qualify for a full or partial tax break due to earned income and contributions to a retirement plan.)

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“I see a lot of people making mistakes here,” Guarino said. The reason is the so-called “pro-rata rule” which requires you to include 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 finding that you can’t get the cream off once you pour it.

“That’s exactly what happens when you mix pre-tax and non-deductible IRAs,” he says, meaning you can’t simply change the after-tax portion.

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

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

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Alternatively, let’s say you have $1 million in a few IRAs and $100,000, or 10% of the total, is a non-deductible contribution. If you turned over $30,000, only $3,000 would be tax-free and $27,000 would be taxed.

Of course, the larger your pre-tax IRA balance, the higher the conversion percentage will be taxable, May said. Otherwise, larger non-deductible balances or Roth IRAs reduce the percentage.

But here’s the kicker: Taxpayers also use Form 8606 to report nondeductible IRA contributions each year to establish your “basis” or after-tax balance.

However, after several years, it is easy to forget the basics, even with professional tax software, May warned. “It’s a big problem,” he said. “If you don’t see it, you’re paying tax twice on the same amount.”

Conversion takes time to avoid ‘unnecessary’ tax hikes

Along with S&P 500 still down about 14% over the past 12 months as of Jan. 19, you may see a Roth conversion. But tax experts say you need to know your 2023 income to understand the tax consequences, which can be difficult at the beginning of the year.

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“I encourage you to wait until the end of the year,” said Tommy Lucas, CFP and enrollment officer at Moisand Fitzgerald Tamayo in Orlando, Florida, noting that income can change from situations such as selling a house or distributing money at the end of the year.

Basically, it aims to “fill in a lower tax bracket,” without hitting someone the next time with Roth income.

For example, if a customer is in the 12% bracket, Lucas may limit the conversion to avoid the 22% spread. Otherwise, they will pay more on their income in taxes in that higher bracket.

“The last thing we want to do is throw people into unnecessary taxes,” he said. And raising income can have other consequences, such as reduced eligibility for certain tax breaks or Medicare Part B and D premiums.

Guarino of Baker Newman Noyes also crunches the numbers before making a Roth conversion decision, noting that he “runs the Form 8606 calculations throughout the year” to know how much how much Roth conversion is taxable income.

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