How Converting to a Roth IRA Can Affect Taxes

For many people, converting a traditional individual retirement account (IRA) to a Roth IRA is a good move. With Roth IRAs, there are no required minimum distributions (RMDs), the money grows tax-deferred, and qualified distributions are tax-free.

However, one drawback is that if your traditional IRA contains both deductible (pretax) and nondeductible (after-tax) amounts, you must treat the pretax portion as ordinary income for the year when the conversion occurs.

In other words, since contributions to Roth IRAs are supposed to be made after tax, you must pay tax on any money you convert into a Roth IRA that you haven’t already paid tax on.

After-Tax Contributions in Traditional IRAs

You might wonder how after-tax amounts even got into your traditional IRA. Aren’t all contributions made to traditional IRAs made before tax? Well, not always. There are three main sources of after-tax funds for traditional IRAs.

The first and most important is that traditional IRAs have deductibility limits that take effect if you or your spouse are deemed to be actively participating in an employer-sponsored retirement plan, such as a defined-contribution 401(k) or defined-benefit pension program. If this is the case, then your eligibility to deduct your contribution from your income taxes is determined by your modified adjusted gross income (MAGI) and your tax filing status.

The tax deduction for a traditional IRA could be reduced or phased out until it is eliminated, depending on filing status and income. Below are the income phaseout ranges for 2024 and 2025:

In other words, if your income goes beyond these ranges, then any deposits that you make would be nondeductible contributions, meaning that there would be no up-front tax break. If you are unable to deduct your contributions, then the amounts will be nondeductible (after-tax) contributions. Even if you are eligible to deduct your contributions, you can choose to treat them as nondeductible contributions.

Second, after-tax money also could end up in your traditional IRA from rollovers from employer plans, such as qualified plans and 403(b) arrangements, as some of these plans allow both pretax and after-tax contributions.

Third, the earnings that you have built up in your traditional IRA are also regarded as pretax by the Internal Revenue Service (IRS). When you convert after-tax money from a traditional IRA to a Roth IRA, the amount is tax-free because you have already paid taxes on those funds. The earnings must be treated as ordinary taxable income.

Tax Rules for Roth IRA Conversions

Suppose that over the years, you contributed $10,000 to your traditional IRA, and either the contributions were nondeductible or you chose not to claim deductions for the amounts. This means that you have already paid taxes on these contributions. Let’s also assume that you picked rotten investments, and the account is worth exactly what you had invested: $10,000. Now, you want to convert the balance to a Roth IRA.

The conversion will be tax-free because you already paid taxes on those funds. If the account had increased in value, you would owe income tax on only the earnings.

On the other hand, if you had deducted those contributions over the years, you would have to include the $10,000 in your income. For example, someone in the 22% tax bracket would have to come up with $2,200 to pay the federal taxes owed on the amount. State income taxes also might apply.

In reality, most people will have a mix of pretax and after-tax income in their traditional IRA, so let’s stick with the same example, but now imagine that you had paid taxes on $2,000 of the $10,000 contributions. You might think you could convert that $2,000 and exclude the amount from your taxable income. Then, the $8,000 of pretax money could continue to grow tax-deferred in the traditional IRA.

Unfortunately, you can’t do that.

The IRS won’t let you cherry-pick your conversions. Instead, the $2,000 that you convert would include a prorated amount of after-tax and pretax amounts in proportion to the after-tax and pretax balances in all of your traditional Simplified Employee Pension (SEP) and Savings Incentive Match Plan for Employees (SIMPLE) IRAs.

Or take an alternative situation: You have several IRAs, one with only after-tax money, while the others have deductible contributions. You might think that you can just convert the IRA with the after-tax amount, and then you won’t need to include the converted amount in your taxable income. You can convert whichever account you want, but that tax strategy won’t work, either.

This is because the IRS considers all your traditional IRA assets as one pool in the calculation formula when you convert all or part of any of those IRAs to a Roth. This includes traditional, SEP, and SIMPLE IRAs. Each dollar converted will be proportionately divided between deductible and nondeductible contributions based on the total value of your traditional IRAs.

Calculating the Conversion Tax

With the above $10,000 example that had $2,000 in after-tax contributions, the $2,000 conversion would play out as follows:

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

The same would apply to earnings in the account. Let’s say that your account has increased to $15,000, and you want to convert $2,000.

• After-tax contributions = $2,000
• Pretax contributions = $8,000
• Earnings = $5,000
• $2,000 ÷ $15,000 = 13%
• $2,000 × 13% = $260 converted tax-free
• $1,740 subject to income tax

Planning a Roth IRA Conversion

Although calculating the formula for multiple non-Roth accounts with deductible and nondeductible contributions can be a nuisance, the process can save you tax dollars.

You must file IRS Form 8606 for each year that you make nondeductible contributions or roll over after-tax amounts to your traditional IRA. Form 8606 also must be filed for any year when you have an after-tax balance in your non–Roth IRAs and you distribute or convert any amount from any of those IRAs.

This is the only way that you’ll know exactly how much of your IRA balance consists of after-tax amounts. The same information will also be useful when you begin taking RMDs or any other distributions from your traditional, SEP, or SIMPLE IRA, as only part of your distributions will be taxable.

Before you convert to a Roth, calculate the tax liability. Make sure that you have enough funds on hand to pay any taxes owed. It’s better to pay the taxes from your non-retirement accounts; otherwise, you will need to include in your income for the year the amount that you withdrew to pay the taxes. This would mean that you may owe income taxes on the amount and early distribution penalties if you are younger than 59½ when the withdrawal occurs.

Here are the 2024 and 2025 Roth IRA income limits to qualify for full or partial contribution eligibility.

The Bottom Line

Converting a traditional IRA to a Roth IRA can be a good move, but if your traditional IRA contains both pretax and after-tax amounts, then special tax rules apply.

The IRS considers all your traditional IRA assets as one pool in the calculation formula when you convert all or part of any of those IRAs to a Roth. This includes traditional, SEP, and SIMPLE IRAs. Each dollar converted will be proportionately divided between deductible and nondeductible contributions based on the total value of all of your traditional IRAs.

Because of this, before you convert to a Roth, you should calculate your tax liability and make sure you have enough funds on hand to pay any taxes owed.