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Robert Bloink and William H. Byrnes

Retirement Planning > Saving for Retirement > IRAs

How to Eliminate Tax on Some Roth IRA Conversions

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What You Need to Know

  • Clients don’t have to pay tax on after-tax or nondeductible IRA contributions, known as basis, when converting to a Roth.
  • Taxpayers must include both pretax contributions and basis when determining the taxes due on a Roth conversion.
  • Clients with after-tax IRA funds may be able to isolate basis and execute an entirely nontaxable Roth conversion.

Most clients understand the benefits of executing Roth IRA conversions over time. A source of tax-free income in retirement can pave the way to reduced income taxes and greater flexibility when it comes to withdrawing retirement funds. 

While most IRA contributions are made with pretax dollars and generate current tax liability when converted, it’s also possible that the client’s IRA could contain nondeductible contributions — called the IRA “basis.”

Clients don’t have to pay tax on IRA basis when converting to a Roth. Tax on conversion is instead applied on a pro rata basis so that only pretax dollars are taxed. For clients with after-tax IRA funds, it may be possible to use exceptions to this pro rata rule to isolate basis and execute an entirely nontaxable Roth conversion.

Pro Rata Rule and Roth Conversions: The Basics

Most traditional IRA contributions are made with pretax dollars to reduce the client’s current taxable income. Once a client’s income exceeds the annual inflation-adjusted thresholds, however, the tax deduction for the original IRA contribution is no longer available. In other words, the client is not able to make pretax contributions to the IRA. A client can, however, make nondeductible contributions to an IRA even when their income is too high to qualify for a tax deduction. 

These nondeductible contributions form the “basis” in the client’s IRA and can be converted (or withdrawn) tax-free (unlike traditional, deductible contributions, which are taxed when converted). After-tax funds that are rolled over from another retirement account will also be added to the account’s basis.

In other words, it’s entirely possible that the client could have both pretax dollars and after-tax dollars in the traditional IRA. Clients can’t pick and choose which dollars to convert to a Roth.

The pro rata rule requires that a taxpayer include all IRA assets (both pretax and after-tax contributions) when determining the taxes due on a Roth conversion. For example, assume a client has $20,000 worth of nondeductible IRA assets and zero pretax dollars in the account. If the client converts the entire $20,000 to a Roth, the client will owe no tax on the conversion because no portion of the converted assets represents pretax (deductible) contributions. 

On the other hand, if the account contains both pretax and after-tax dollars, a proportionate percentage of each dollar converted will be taxable (so pretax contributions are taxed and after-tax contributions are not taxed again upon conversion. If the account contained $20,000 in nondeductible contributions and $10,000 in pretax contributions, one-third of the amount converted would be taxable under the pro rata rule.

Exceptions to the Pro Rata Rule

If the client can isolate the after-tax contributions (i.e., the account’s basis) so that no pretax dollars remain in the account, it’s possible to execute a tax-free Roth conversion. A few workarounds do exist to allow the client to remove pretax funds from the IRA and reduce (or eliminate) the need to calculate tax on conversion under the pro rata rule.

Making a rollover from an IRA to an employer-sponsored 401(k) or retirement plan is perhaps the most widely used exception to the pro rata rule. Only pretax IRA contributions can be rolled into the employer-sponsored plan. This strategy can allow the IRA owner to remove pretax contributions from the IRA, isolating the IRA to solely after-tax contributions that can be used to execute a tax-free Roth conversion. 

Note, however, that the IRA-to-401(k) rollover strategy works only if the client has access to an employer-sponsored retirement plan that accepts IRA rollovers.

Other Strategies: QCDs and HSAs

Clients who have reached age 70½ may wish to consider the qualified charitable distribution strategy. Once the client reaches age 70½, a transfer made directly from the client’s IRA to a qualified charity (generally, 501(c)(3) organizations, but not donor-advised funds, foundations or charitable gift annuities) will count toward the client’s RMD and is entirely nontaxable. Only pretax contributions can be transferred via the QCD strategy.

Clients who are eligible to fund a health savings account also have the option of rolling pretax IRA dollars into an HSA. The client can execute only one IRA-to-HSA transfer in a lifetime — and the amount transferred is limited to the annual HSA contribution limit for the year. In 2022, the maximum family HSA contribution is $7,300 ($8,300 for clients aged 55 and older).

Conclusion

The pro rata rule often catches clients by surprise when executing a Roth conversion — and some might even worry that they’re being taxed twice on the same funds. Using strategies to isolate IRA basis and minimize (or even eliminate) taxes on conversion can help clients with mixed IRA funds maximize the value of a current Roth conversion.

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