If there's one common agreement among financial planners it's undoubtedly that the Roth IRA is hands down the best retirement vehicle available to individuals. Two of the main reasons attributable to this include that the Roth offers tax-free withdrawal of contributions and earnings upon reaching retirement and that the Roth has no Required Minimum Distribution (RMD) withdrawals at age 70 1/2. Unfortunately, based on your earned income, not everyone can directly contribute to a Roth IRA.

Why the Roth IRA?
As a single taxpayer, if you have earned income (modified AGI) of $125,000 or greater, you cannot contribute to a Roth IRA. For married individuals, this amount is $183,000 (these current limits for 2012 can be indexed upward annually). However, anyone can contribute up to $5,000 per year (indexed for 2012) to a Traditional IRA regardless of the amount of his or her earned income, just as long as his or her contribution does not exceed the lesser of $5,000 or the amount of his or her earned income. (Age 50 or older also has a $1,000 additional catch-up amount)

Traditional IRA Vs. the Non-Deductible IRA
Up to certain earned income limitations (that typically change annually), taxpayers in lower tax brackets can receive an IRA contribution deduction on their federal tax returns for deposits made to a Traditional IRA for the year. If you happen to earn over the IRS limits, you can still contribute to an IRA, but you will not be entitled to an IRA contribution deduction on your tax return. This is known as a non-deductible IRA contribution," which requires you to file Form 8606 with your tax return listing the contribution as such. Since you never received a tax deduction for these contributions, these "non-deductible" contribution amounts are not taxed when withdrawn from the IRA account and they are commonly known as "basis."

Converting IRAs to Roth IRA
In 2010, Congress eliminated the $100,000 income limit on Roth IRA conversions. This allows Traditional IRA owners in all tax brackets to convert their IRAs to Roth and pay tax now to receive tax-free benefits in retirement. What if all of your IRA savings are comprised of non-deductible IRA contributions? If this is the case, then you can convert your entire Non-deductible IRA to a Roth IRA, and you'll only have to pay tax on the earnings portion.
For example, Susan Smith is in a 30% tax bracket this year and she only has one IRA worth $100,000. The IRA consists of $90,000 in non-deductible contributions and $10,000 in earnings. If she decides to convert the entire IRA to Roth, she would only have to pay tax on the earnings portion ($10,000). At a 30% tax rate, she would owe $3,000 in tax to convert the entire $100,000 to Roth.

If Smith had no earnings in this IRA, the entire $100,000 (all non-deductible contributions) could be converted with no tax liability. When earnings are present, the owner must consider if it would be more beneficial to him or her, or his or her heirs, to pay the tax due now, considering that the future benefit would be tax-free.

Where It Gets Tricky
When you have an IRA that contains normal contributions, non-deductible contributions and earnings, the rules of conversions are more complex. It would be fantastic if you could simply single out the non-deductible contributions and only convert that portion to the Roth tax-free. However, we all know the IRS quite well and it wants its piece of the pie. Let's take a look at the special tax treatment of partial conversions for owners with multiple IRA accounts or IRAs with both deductible and non-deductible contributions.

John Doe, a 30% taxpayer, has a Traditional IRA worth $200,000 on Dec. 31, 2012, of which $100,000 is non-deductible contributions. Doe wants to convert $100,000 of this IRA to Roth. Because Doe has $100,000 of non-deductible contributions in this Traditional IRA, you would think that he could convert the $100,000 of non-deductible contributions tax-free. Unfortunately, the IRS has a special formula that must be followed if you own an IRA with normal contributions.

Here's how it works:

Tax-free Percentage = Total Non-deductible Contributions divided by
(Sum of year-end value of all IRA accounts + Conversion Amount)
= $100,000/($200,000 + $100,000) = $100,000/$300,000

Tax-Free amount of Conversion = 33.3% (or $33,333)

Therefore, if John converts $100,000 to the Roth, he will have $33,333 ($100,000 x 33.3%) that is not-taxed and $66,667 ($100,000 x 66.7%) that will be taxed at his 30% tax rate.

The Bottom Line
As you research this topic, you'll find many financial planner recommendations and articles on this subject are written incorrectly. The common misconception is that you can single out the non-deductible contributions and convert them specifically tax-free. Another misconception is that you simply divide the non-deductible contributions by the total value of the IRAs and this is the tax-exempt amount percentage. Unfortunately, the formula is a little more complex than both methods just mentioned. Now you know the rules, and doing the calculation correctly will keep the IRS off your back.

Related Articles
  1. Taxes

    An Introduction to Roth IRAs

    Be sure to consider the tax benefits and the eligibility requirements of the Roth IRA.
  2. Retirement

    Roth vs. Traditional IRA: Which Is Right For You?

    To answer this question, you need to consider several of the factors we outline here.
  3. Taxes

    9 Penalty-Free IRA Withdrawals

    If you need to take early distributions, find out which exemptions allow you to avoid expensive consequences.
  4. Taxes

    An Introduction To Correcting Ineligible IRA Contributions

    Eager to save for retirement? Find out how to avoid overpayment penalties.
  5. Taxes

    Analyzing IRA And ESA Statements

    Learn how to read and verify 5498 and 5498-ESA reporting your retirement-account contributions.
  6. Taxes

    4 IRA Changes That Encourage Savings

    Find out what's new in the world of IRAs and how you can get more bang for your buck.
  7. Mutual Funds & ETFs

    Top 3 PIMCO Funds for Retirement Diversification in 2016

    Explore analyses of the top three PIMCO funds for 2016 and learn how these funds can be used to create a diversified retirement portfolio.
  8. Retirement

    How Much Should You Have In Your 401(k) To Retire?

    Determining how much money should be in your 401(k) when you retire depends on several variables, many of which are uncertain.
  9. Retirement

    Retiring in Thailand: The Pros & Cons

    It's a lovely land, but before relocating, get the skinny on this Southeast Asian kingdom.
  10. Investing

    How To Make Sure Your Healthcare Costs Do Not Ruin Your Retirement

    The best proactive plan of action for a stable retirement is to understand medical costs, plan ahead, invest properly, and consider supplemental insurance.
RELATED FAQS
  1. Am I losing the right to collect spousal Social Security benefits before I collect ...

    The short answer is yes, if you haven't reached age 62 by December 31, 2015. The Bipartisan Budget Act of 2015 disrupted ... Read Full Answer >>
  2. What is the maximum I can receive from my Social Security retirement benefit?

    The maximum monthly Social Security benefit payment for a person retiring in 2016 at full retirement age is $2,639. However, ... Read Full Answer >>
  3. Are target-date retirement funds good investments?

    The main benefit of target-date retirement funds is convenience. If you really don't want to bother with your retirement ... Read Full Answer >>
  4. Where else can I save for retirement after I max out my Roth IRA?

    With uncertainty about the sustainability of Social Security benefits for future retirees, a lot of responsibility for saving ... Read Full Answer >>
  5. Will quitting your job hurt your 401(k)?

    Quitting a job doesn't have to impact a 401(k) balance negatively. In fact, it may actually help in the long run. When leaving ... Read Full Answer >>
  6. How does my spousal Social Security benefit work?

    If you have never worked or paid Social Security taxes, you will not be eligible to receive Social Security retirement benefits ... Read Full Answer >>
Trading Center