Experts say anyone who switched to a Roth individual retirement account in 2022 is likely to have a more complicated tax return this season.
The strategy of transferring pre-tax or non-deductible IRA funds to a Roth IRA for future tax-free growth tends to be more popular during a stock market downturn because you can convert more assets at a lower dollar amount. While the trade-off is upfront taxes, you may have less income if you convert lower value assets.
“You get more bang for your buck,” said Jim Guarino, board-certified financial planner and general manager at Baker Newman Noyes in Woburn, Massachusetts. He is also an auditor.
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If you completed a Roth conversion in 2022, your custodian will give you a Form 1099-R, which contains the distribution from 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, if there is a mix of pre-tax and non-deductible IRA contributions over time, the calculation can be more difficult than you expect. (You may have non-deductible contributions in your pre-tax IRA if you do not qualify for full or partial tax credit from participation in income and company pension plans.)
“I see a lot of people making mistakes here,” Guarino said. The reason is what’s called the “pro rata rule,” which requires you to include your total pre-tax IRA funds in the calculation.
This is how the pro rata rule works
JoAnn May, CFP and CPA at Forest Asset Management in Berwyn, Illinois, said the pro rata rule is the equivalent of adding cream to your coffee and then realizing you can’t remove the cream after you pour it.
“That’s what happens when you mix pre-tax and non-deductible IRAs,” she said, meaning you can’t just convert the after-tax portion.
For example, let’s say you have a pre-tax IRA of $20,000 and you made a nondeductible IRA contribution of $6,000 in 2022.
If you were converting 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 some IRAs and $100,000 or 10% of the total are non-deductible contributions. If you convert $30,000, only $3,000 would be tax-exempt and $27,000 taxable.
Of course, the larger your pre-tax IRA balance, the higher the percentage of the conversion that’s taxable, May said. Alternatively, a larger nondeductible or Roth IRA balance reduces the percentage.
But here’s the kicker: Taxpayers also use Form 8606 to report nondeductible IRA contributions each year to create a “base,” or your after-tax balance.
However, after a few years, it is easy to lose track even with professional tax software, May warned. “That’s a big problem,” she said. “If you miss it, you’re basically paying the same money twice.”
Timing of conversions to avoid an “unnecessary” tax increase
With the S&P 500 still down about 14% over the trailing 12 months ended Jan. 19, you might be eyeing a Roth conversion. However, tax experts say you need to know your income for 2023 to understand the tax ramifications, which can be difficult early in the year.
“I recommend waiting until the end of the year,” said Tommy Lucas, a CFP and registered agent at Moisand Fitzgerald Tamayo in Orlando, Fla., noting that income can be affected by factors such as selling a home or paying out mutual funds may change at the end of the year.
Typically, he aims to “fill up a lower tax bracket” without bumping someone with Roth conversion income into the next.
For example, if a customer is in the 12% tier, Lucas can restrict the conversion to avoid it going to the 22% tier. Otherwise, they pay more on taxable income in that higher class.
“The last thing we want to do is put someone in an unnecessary tax bracket,” he said. And the increase in income may have other consequences, such as: B. Reduced eligibility for certain tax benefits or higher Medicare Part B and D premiums.
Guarino of Baker Newman Noyes also crunches the numbers before making Roth conversion decisions, noting that he “essentially does the Form 8606 calculation during the year” to know how much of the Roth conversion is taxable income will be.