If you did a Roth IRA conversion in 2022, you may have a trickier tax return this season, experts say.
The strategy, which transfers pre-tax or non-deductible IRA funds into 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 amount in dollars Although the compensation is upfront taxes, you may have less income by converting lower value investments.
“You get more money,” said Jim Guarino, a certified financial planner and managing director of 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 your custodian’s Form 1099-R, which includes your IRA distribution, Guarino said.
You’ll need to report the rollover on Form 8606 to tell the IRS how much 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 expect. (You may have non-deductible contributions to your IRA before taxes if you are not eligible for full or partial tax relief because of earnings and participation in the workplace retirement plan.)
“I see a lot of people making mistakes here,” Guarino said. The reason is the so-called “proportionate rule” that requires you to include your pre-tax aggregated IRA funds in the calculation.
How the proration rule works
JoAnn May, CFP and CPA with Forest Asset Management in Berwyn, Illinois, said the proration rule is the equivalent of adding cream to coffee and finding you can’t get the cream off once it’s poured.
“That’s exactly what happens when you mix pre-tax and non-deductible IRAs,” he said, meaning you can’t simply convert the after-tax portion.
For example, say you have a pre-tax IRA of $20,000 and you made a non-deductible IRA contribution of $6,000 in 2022.
If you were to convert the entire balance of $26,000, you would divide $6,000 by $26,000 to calculate the tax-free portion. That means about 23% or about $6,000 is tax-free and $20,000 is taxable.
Alternatively, let’s say you have $1 million in a few IRAs and $100,000, or 10% of the total, are non-deductible contributions. If you convert $30,000, only $3,000 would be non-taxable and $27,000 would be taxable.
Of course, the larger the pretax IRA balance, the higher the conversion percentage, May said. Alternatively, a larger non-deductible balance or Roth IRA lowers the percentage.
But here’s the kicker: Taxpayers also use Form 8606 to report nondeductible IRA contributions each year to establish “basis,” or your after-tax balance.
However, after several years, it’s easy to lose track of the basics, even in professional tax software, May warned. “It’s a big problem,” he said. “If you miss it, you’re basically paying taxes on the same money twice.”
Temporary conversions to avoid an “unnecessary” tax increase.
With the S&P 500 it is still down 14% over the last 12 months from January. 19, you may be looking at a Roth conversion. But tax experts say you need to know your 2023 income to know the tax consequences, which can be difficult early in the year.
“I recommend waiting until the end of the year,” said Tommy Lucas, a CFP and enrolled agent at Moisand Fitzgerald Tamayo in Orlando, Fla., noting that income can change due to factors such as selling a home or the distributions of investment funds at the end of the year.
It’s usually aimed at “filling in a lower tax bracket,” without bumping someone into the next one with Roth conversion income.
For example, if a customer is at the 12% level, Lucas can limit the conversion to prevent it from falling to the 22% level. Otherwise, they will pay more for the taxable income in that higher bracket.
“The last thing we want to do is 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’ Guarino also crunches the numbers before making Roth conversion decisions, noting that “you’re essentially doing the Form 8606 calculation for the year” to figure out how much of the Roth conversion will be taxable income.