If you made a transfer to a Roth individual retirement account in 2022, you may have a more complex tax return this season, experts say.
Pre-tax transfer strategy Non-deductible IRA Funds to a Roth IRA for tax-free future growth tend to be more common during a Stock market downturn Because you can transfer more assets with less dollar amount. While the trade-off is pre-taxed, you may have less income by shifting low-value investments.
“You get more for your money,” said Jim Guarino, certified financial planner and managing director at Baker Newman Noyes in Woburn, Massachusetts. He is also a Certified Public Accountant.
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If you complete a Roth conversion in 2022, you will receive Form 1099-R from your trustee, which includes distributions from your IRA, Guarino said.
You will need to notify the transfer with a date Figure 8606 To tell the IRS what part of your Roth conversion is taxable, he said. However, when there’s a mix of pretax and non-deductible IRA contributions over time, the calculation can be more complicated than you expect. (You may have non-deductible contributions to your pre-tax IRA if you don’t qualify for full or partial tax relief due to participation in a workplace and income retirement plan.)
“I see a lot of people making a mistake here,” Guarino said. The reason is the so-called “proportionate rule” which requires you to factor out the total pre-tax IRA funds in the account.
How does the proportional rule work?
The rule of proportion is equivalent to adding cream to your coffee and then finding that you can’t remove the cream once you’ve poured it, said JoAnn May, a CFP and CPA with Forest Asset Management in Berwyn, Illinois.
“That’s exactly what happens when you mix pre-tax and non-deductible IRAs,” she said, which means you can’t simply roll over the after-tax portion.
For example, let’s say you have a pre-tax IRA of $20,000 and you make a non-deductible IRA contribution of $6,000 in 2022.
If you transfer the total balance of $26,000, you’ll divide $6,000 by $26,000 to calculate the tax-free portion. This means that approximately 23% or about $6,000 is tax-free and $20,000 is taxable.
Alternatively, let’s say you have $1 million across a few IRA accounts and $100,000, or 10% of the total, are non-deductible contributions. If you transfer $30,000, only $3,000 will be non-taxable and $27,000 will be taxable.
Of course, May said, the higher the pre-tax IRA balance, the higher the conversion percentage will be taxable. Instead, a larger non-deductible or Roth IRA balance reduces the percentage.
But here’s the key: Taxpayers also use Form 8606 to report non-deductible IRA contributions each year to create a “base,” or your after-tax balance.
However, after so many years, it’s easy to lose track of the basics, even in professional tax software, May warned. “It’s a big deal,” she said. “If you miss, you’re basically paying tax on the same money twice.”
Timing transfers to avoid ‘unnecessary’ tax hikes
with the Standard & Poor’s 500 Still down about 14% over the past 12 months as of January 19th, you’re probably looking forward to a Roth conversion. But tax experts say you need to know your 2023 income to know the tax consequences, which can be difficult early in the year.
“I recommend waiting until the end of the year,” said Tommy Lucas, CFP agent and registrar at Moisand Fitzgerald Tamayo in Orlando, Florida, noting that income can change from factors like sell a house or the end of the year mutual fund distributions.
Typically, it aims to “fill in a lower tax bracket,” without bumping into someone in the next bracket with Roth conversion income.
For example, if a customer is in the 12% bracket, Lucas might limit the conversion to avoid spillage in the 22% bracket. Otherwise, they will pay more on taxable income in that higher bracket.
“The last thing we want to do is put someone into an unnecessary tax bracket,” he said. Increased income may have other consequences, such as decreased eligibility for certain tax breaks or Higher premiums from Medicare Part B and D.
Guarino of Baker Newman Noyes also crunches the numbers before making Roth conversion decisions, noting that he “essentially does a Form 8606 calculation during the year” to see how much of a Roth conversion would be taxable income.