Quick housekeeping note: My wife and I are on vacation for the next couple of weeks, so there will be a gap in the publishing schedule. The next article will be published on Friday 5/8.
A reader writes in, asking:
“On several occasions, you’ve explained Roth conversions with language that indicates you can convert parts of your traditional IRAs to a Roth over time, for a variety of reasons.
When I looked into doing this several years ago, I encountered the rule that required you to value ALL your traditional IRAs and pay the tax on the full value of all of them converted. I decided against it because that didn’t make sense to me (why would I convert only part when I have to pay tax as if I converted all of them).
Did I misunderstand the rules? Is there something else I am missing? I see so little reference to this anywhere.”
Yes, you can do a partial conversion. And in no case will you have to pay tax on more than the amount converted. To be more specific:
- If your traditional IRA(s) do not contain any amounts from nondeductible contributions, the amount of the conversion will be included in your taxable income for the year, and
- If you do have amounts from nondeductible contributions in your traditional IRA(s), a portion of the conversion will be included in your taxable income.
Most likely, the misunderstanding arose from the fact that the IRS aggregates all of your traditional IRAs when calculating the taxable percentage of a conversion. That is, if you have multiple traditional IRAs, they’re all considered to be one big traditional IRA for the purpose of this calculation.*
The percentage of the conversion that is not taxable is calculated as:
- The sum of all non-deductible contributions in all of your traditional IRA, divided by
- The sum of: all of your traditional IRA balances on 12/31 of the year of the conversion, plus any distributions you made during the year, plus any conversions made during the year.
The idea behind this calculation is to make it so that you won’t have to pay tax twice on a given amount of money. That is, if you didn’t get a deduction when you put money into the traditional IRA (i.e., you paid tax on the money before it went into the account), then you should not have to pay tax again when you move the money to a Roth IRA.
For example, if you have one traditional IRA, and it has a value of $10,000, of which $3,000 came from non-deductible contributions, and you convert the entire traditional IRA, only $7,000 of the conversion would be taxable. The $3,000 nondeductible contribution gets to be converted tax-free.
But in the event of a partial conversion, you don’t get to choose which dollars get converted. Instead, your conversion is considered to come from non-deductible contributions and from pre-tax money on a pro-rata basis — hence the need for the math above.
*This is not true for all IRA-related applications. In some cases, the IRS does consider separate accounts to be separate accounts.