Non-Deductible IRA Contributions and Conversion to a Roth
Please elaborate on information in the most recent newsletter regarding in 2010, that a high net worth client could make a Non-deductible contribution to a Traditional IRA and then convert it to a Roth IRA. How would the taxes work on the conversion? Would the client have to pay taxes on the full conversion amount, even though they never received the deduction on the Traditional IRA contribution?
Permalink Submitted by Anonymous (not verified) on Wed, 2009-06-24 16:45
I have not read the newsletter article, but here are my thoughts on the issue:
Conversions are always taxed on a pro-rata basis. So, if a HNW client made ONLY non-deductible contributions and converts it all, only the earnings (if any, would be taxed). If a partial amount is converted, then only the percentage portion that is pre-tax. Things get slightly more complicated, if he/she has other IRAs out there that maybe be rollovers from 401Ks (all pre-tax). They are then also included in this formula, even though the funds (investments) he/she may be converting are only these non-deductible contributions.
Example: (assuming balances remain at those levels)
HNW client contributes 5K at Fidelity in 2007 (non-deductible)
HNW client has Rollover IRA at Schwab 100K
Client converts 5K at Fidelity in 2008
100 pre-tax/105 total= about 95%
95% of the 5K will be taxed during the conversion!
Take the Rollover IRA out: nothing will be taxed becasue the money is after-tax.
In summary, those that have been contributing for several years on a non-deductible basis, have no other pre-tax IRAs, and have their basis still intact will gain the most. Their conversions will be a way to get a lot of money into a Roth before 2010.
[IRS has it’s own formula in Pub 590 using several worksheets, I just simplified]