3713.03 / Is there any way to execute a non-taxable Roth conversion?

While most IRA contributions are made with pre-tax dollars and generate current tax liability when converted, it is also possible that the taxpayer’s IRA could contain nondeductible contributions—called the IRA “basis.” Taxpayers are not required 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 pre-tax dollars are taxed. For taxpayers 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.

Most traditional IRA contributions are made with pre-tax dollars to reduce the taxpayer’s current taxable income. However, once a taxpayer’s income exceeds the annual inflation-adjusted thresholds, the tax deduction for the original IRA contribution is no longer available (i.e., the taxpayer is not able to make pre-tax contributions to the IRA). A taxpayer 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These nondeductible contributions form the “basis” in the IRA and can be converted (or withdrawn) tax-free (unlike traditional, deductible contributions, which are taxed when converted).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 taxpayer could have both pre-tax dollars and after-tax dollars in the traditional IRA. Taxpayers 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 pre-tax and after-tax contributions) when determining the taxes due on a Roth conversion. For example, assume a taxpayer has $20,000 worth of nondeductible IRA assets and zero pre-tax dollars in the account. If the taxpayer converts the entire $20,000 to a Roth, the taxpayer will owe no tax on the conversion because no portion of the converted assets represent pre-tax (deductible) contributions.

On the other hand, if the account contains both pre-tax and after-tax dollars, a proportionate percentage of each dollar converted will be taxable (so pre-tax 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 pre-tax contributions, 1/3 of the amount converted would be taxable under the pro rata rule.

If the taxpayer can isolate the after-tax contributions (i.e., the account’s basis) so that no pre-tax dollars remain in the account, it’s possible to execute a tax-free Roth conversion. A few workarounds do exist to allow the taxpayer to remove pre-tax funds from the IRA and reduce (or eliminate) the need to calculate tax on conversion under the pro rata rule.

Making a rollover from an IRA to an employer-sponsored 401(k) or retirement plan is perhaps the most widely used “exception” to the pro rata rule. Only pre-tax IRA contributions can be rolled into the employer-sponsored plan. This strategy can allow the IRA owner to remove pre-tax contributions from the IRA, isolating the IRA to solely after-tax contributions that can be used to execute a tax-free Roth conversion.

Note, however, that the IRA-to-401(k) rollover strategy only works if the taxpayer has access to an employer-sponsored retirement plan that accepts IRA rollovers.

Taxpayers who have reached age 70 ½ may wish to consider the qualified charitable distribution strategy. Once the taxpayer reaches age 70 ½, a transfer made directly from the IRA to a qualified charity (generally, 501(c)(3) organizations, but not donor-advised funds, foundations or charitable gift annuities) will count toward the taxpayer’s RMD and is entirely nontaxable. Only pre-tax contributions can be transferred via the QCD strategy.

Taxpayers who are eligible to fund an HSA also have the option of rolling pre-tax IRA dollars into an HSA. The taxpayer can only execute one IRA-to-HSA transfer in a lifetime—and the amount transferred is limited to the annual HSA contribution limit for the year.