How IRA Contributions Affect Your Taxes

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How IRA Contributions Affect Your Taxes
2021 and 2022 Traditional IRA Deduction Limits
Filing Status2021 MAGI2022 MAGIDeduction
Single or head of household$66,000 or less$68,000 or lessFull deduction up to the amount of thecontribution limit
More than $66,000 but less than $76,000More than $68,000 but less than $78,000Partial deduction
$76,000 or more$78,000 or moreNo deduction
Married filing jointlyorqualifying widow(er)$105,000 or less$109,000 or lessFull deduction up to the amount of thecontribution limit
More than $105,000 but less than $125,000More than $109,000 but less than $129,000Partial deduction
$125,000 or more$129,000 or moreNo deduction
Married filing separatelyLess than $10,000Less than $10,000Partial deduction
$10,000 or more$10,000 or moreNo deduction

In other words, if your income exceeds these limits, any deposits you make will be nondeductible, which means there will be no tax advantage up front. If you are unable to deduct your donations, the amounts will be considered nondeductible (after-tax). Even though your donations are deductible, you might opt to classify them as nondeductible contributions.

Second, since certain employer plans allow both pretax and after-tax contributions, after-tax money may wind up in your conventional IRA via rollovers from qualifying plans and 403(b) arrangements.

Third, the profits in your conventional IRA are likewise considered pretax by the Internal Revenue Service (IRS).Because you have already paid taxes on the funds, converting after-tax money from a standard IRA to a Roth IRA is tax-free. Earnings must be considered regular taxable income.

Tax Rules for Roth IRA Conversions

Assume you contributed $10,000 to your conventional IRA throughout the years and either the contributions were nondeductible or you elected not to claim the amounts as deductions. This indicates you’ve already paid taxes on your donations. Assume you made poor investing choices and the account is worth precisely what you invested: $10,000. You wish to convert the remaining amount to a Roth IRA.

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Because you have paid taxes on those money, the conversion will be tax-free. If the account’s value rose, you would owe income tax solely on the profits.

If you had deducted those donations over time, you would have had to include the $10,000 in your income. For example, someone in the 22% tax rate would have to pay $2,200 in federal taxes on the amount. State income taxes may also apply.

In fact, most individuals would have a mix of pretax and after-tax income in their conventional IRA, so let’s use the same example, but this time pretend you paid taxes on $2,000 of the $10,000 contributions. You may believe that you may convert that $2,000 and deduct it from your taxable income. The $8,000 in pretax funds might then grow tax-free in the regular IRA.

Unfortunately, you can’t do that.

The IRS will not allow you to pick and choose which conversions you make. Instead, the $2,000 that you convert would contain a prorated amount of after-tax and pre-tax amounts based on the after-tax and pre-tax balances in all of your regular, SEP, and SIMPLE IRAs.

Consider this scenario: you have multiple IRAs, one with just after-tax money and the others with deductible contributions. You may believe that by converting the IRA with the after-tax amount, you would not have to include the converted amount in your taxable income. You can convert whatever account you want, but that tax technique will also fail.

When you convert all or portion of any of your conventional IRAs to a Roth, the IRS treats all of your traditional IRA assets as a single pool in the computation procedure. Traditional, SEP, and SIMPLE IRAs are all included. Based on the total value of all of your traditional IRAs, each dollar converted will be proportionally split between deductible and nondeductible contributions.

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Calculating the Conversion Tax

In the $10,000 example above, with $2,000 in after-tax contributions, the $2,000 conversion would look like this:

  • Total account value = $10,000
  • Contributions after taxes = $2,000
  • Pretax contributions = $8,000
  • $2,000 ÷ $10,000 = 20%
  • $2,000 converted at 20% = $400 tax-free
  • $1,600 subject to income tax

The same holds true for account earnings. Assume your account has grown to $15,000 and you wish to convert $2,000.

  • Contributions after taxes = $2,000
  • Pretax contributions = $8,000
  • Earnings = $5,000
  • $2,000 ÷ $15,000 = 13%
  • $2,000 x 13% = $260 tax-free conversion
  • $1,740 subject to income tax

Maintain accurate records of all your IRA contributions since your IRA custodian is not compelled to do so.

Planning a Roth IRA Conversion

Although computing the calculation for many non-Roth accounts with deductible and nondeductible contributions might be time consuming, it can save you money in the long run.

For each year in which you make nondeductible contributions or roll over after-tax monies to your traditional IRA, you must complete IRS Form 8606. Form 8606 must also be submitted if you have an after-tax balance in your non-Roth IRAs and distribute or convert any money from any of those IRAs in any year. This is the only method to determine how much of your IRA balance is made up of after-tax funds. The same information will be useful when it comes time to start drawing RMDs or other distributions from your conventional, SEP, or SIMPLE IRA, since only a portion of your withdrawals will be taxed.

Calculate your tax obligation before converting to a Roth. Make sure you have enough money on hand to pay any taxes that are required. It is preferable to pay taxes from non-retirement funds; otherwise, you must include the amount withdrawn to pay taxes in your income for the year. This means you may owe not just income taxes on the amount, but also early distribution penalties if you are under the age of 5912 at the time of the withdrawal.

  Tax Roll Definition

2021 and 2022 Roth IRA Income Limits
Filing Status2021 MAGI2022 MAGIContribution Limit
Married filing jointly or qualifying widow(er)Less than $198,000Less than $204,000$6,000 ($7,000 if you’re age 50 or older)
$198,000 to $207,999$204,000 to $213,999Reduced
$208,000 or more$214,000 or moreNot eligible
Single, head of household, or married filing separately (and you didn’t live with your spouse at any time during the year)Less than $125,000Less than $129,000$6,000 ($7,000 if you’re age 50 or older)
$125,000 to $139,999$129,000 to $143,999Reduced
$140,000 or more$144,000 or moreNot eligible
Married filing separately (if you lived with your spouse at any time during the year)Less than $10,000Less than $10,000Reduced
$10,000 or more$10,000 or moreNot eligible

How are taxes paid on a Roth individual retirement account (Roth IRA) conversion?

The Internal Revenue Service (IRS) will collect the federal tax on a Roth individual retirement account (Roth IRA) conversion together with the rest of your income taxes payable on the return you submit for the year of the conversion. Losses and deductions recorded on the same tax return may often offset the regular income earned by a Roth IRA conversion.

Can I withdraw contributions from a Roth IRA conversion without penalty?

You may withdraw direct contributions to your Roth IRA tax-free and penalty-free at any time. However, you may have to pay taxes and penalties on your Roth IRA profits.

Can I do multiple Roth conversions in a year?

In 2021 and 2022, the federal government enables you to contribute $6,000 directly to a Roth IRA, or $7,000 if you’re 50 or older. There is, however, no limit to the amount you may transfer from tax-deferred savings to your Roth IRA in a single year. Just be careful to analyze the tax implications before converting huge sums.

The Bottom Line

Converting a conventional IRA to a Roth IRA may be a wise decision; but, if your traditional IRA includes both pretax and after-tax funds, unique tax regulations apply.

When you convert all or portion of any of your conventional IRAs to a Roth, the IRS treats all of your traditional IRA assets as a single pool in the computation procedure. Traditional, SEP, and SIMPLE IRAs are all included. Based on the total value of all of your traditional IRAs, each dollar converted will be proportionally split between deductible and nondeductible contributions.

As a result, before converting to a Roth, you should analyze your tax burden and ensure that you have sufficient assets on hand to pay any taxes required.

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