Most clients understand the benefits of executing Roth IRA conversions over time. A source of tax-free income in retirement can pave the way to reduced income taxes and greater flexibility when it comes to withdrawing retirement funds.
While most IRA contributions are made with pretax dollars and generate current tax liability when converted, it's also possible that the client's IRA could contain nondeductible contributions — called the IRA "basis."
Clients don't have to pay tax on IRA basis when converting to a Roth. Tax on conversion is instead applied on a pro rata basis so that only pretax dollars are taxed. For clients with after-tax IRA funds, it may be possible to use exceptions to this pro rata rule to isolate basis and execute an entirely nontaxable Roth conversion.
Pro Rata Rule and Roth Conversions: The Basics
Most traditional IRA contributions are made with pretax dollars to reduce the client's current taxable income. Once a client's income exceeds the annual inflation-adjusted thresholds, however, the tax deduction for the original IRA contribution is no longer available. In other words, the client is not able to make pretax contributions to the IRA. A client can, however, make nondeductible contributions to an IRA even when their income is too high to qualify for a tax deduction.
These nondeductible contributions form the "basis" in the client's IRA and can be converted (or withdrawn) tax-free (unlike traditional, deductible contributions, which are taxed when converted). After-tax funds that are rolled over from another retirement account will also be added to the account's basis.
In other words, it's entirely possible that the client could have both pretax dollars and after-tax dollars in the traditional IRA. Clients can't pick and choose which dollars to convert to a Roth.
The pro rata rule requires that a taxpayer include all IRA assets (both pretax and after-tax contributions) when determining the taxes due on a Roth conversion. For example, assume a client has $20,000 worth of nondeductible IRA assets and zero pretax dollars in the account. If the client converts the entire $20,000 to a Roth, the client will owe no tax on the conversion because no portion of the converted assets represents pretax (deductible) contributions.
On the other hand, if the account contains both pretax and after-tax dollars, a proportionate percentage of each dollar converted will be taxable (so pretax contributions are taxed and after-tax contributions are not taxed again upon conversion. If the account contained $20,000 in nondeductible contributions and $10,000 in pretax contributions, one-third of the amount converted would be taxable under the pro rata rule.
