Roth Conversion for Dummies (I don't know how to do taxes!)

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PA86
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Roth Conversion for Dummies (I don't know how to do taxes!)

Post by PA86 »

Hello Braintrust, I have a very rudimentary question regarding a Roth conversion.

My fiance has about 500K in a Traditional IRA. She is in the 22% Federal tax bracket. We think it makes sense to convert a portion of this to a Roth.

We understand that we will pay taxes only on the amount converted, and all our holdings are with Vanguard, so the actual conversion is simple.

My question is... how does the tax reporting actually occur?

Neither of us has ever done a conversion before. Is there a particular form that gets filled out at tax time? How does the converted amount become factored into our taxable income?

Thanks!
jebmke
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by jebmke »

You will receive a 1099-R which has the amount of the conversion. This is reported (by you) on Line 4a and 4b of your form 1040. It will be added to all your other income and, after adjustments and deductions become part of taxable income.
Don't trust me, look it up. https://www.irs.gov/forms-instructions-and-publications
Silk McCue
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by Silk McCue »

The converted amount will be taxed as Ordinary Income just like their employment income. The amount converted is stacked on top of the total and will be in the 22% and higher brackets depending upon the total converted.

Please use this excellent tax tool used by many here to model the impact of various conversions. Start out by properly populating the data without the Roth conversion to get a sanity check on the proper use of the tool. Then add in conversion scenarios to determine the tax impact.

https://www.mortgagecalculator.org/calc ... ulator.php

Cheers
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PA86
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by PA86 »

I'm a little confused about deductible and non deductible funds.

The traditional IRA has not been contributed to in years.

Let's say we convert $5,000 from the traditional to Roth this year.

Do I have to know anything more complex than the fact that we have an additional $5,000 of taxable income this year?
chemocean
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by chemocean »

Vanguard will issue you a tax form, I think it is 1099-R that you will report on line 4 of your 1040.
As far as paying the taxes, the three ways that I know of are:
1) increase withholding from your wage job,
2) use 4 equal payments using the quarterly voucher, or
3) pay the taxes in the quarter for which you do the conversion and fill out form (2210) which is onerous.

The first year she converts, she probably can wait until April 15 of the following year to pay taxes if she fall under the safe harbor rule of the previous year tax withholding.

If IRMMA Medicare premiums (starting at 63, but could be appealed based on your marriage date), and QCDs, for those over 70.5, are applicable, this forum would have some advice on how to stretch the conversions over several years. Also, you should examine if there is a tax advantage to waiting to you are married and married filing jointly, or for allowing more conversations to take place annually but still stay within the larger 2% bracket with the MFJ.
retire2022
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by retire2022 »

PA86 wrote: Wed Dec 01, 2021 12:39 pm I'm a little confused about deductible and non deductible funds.

The traditional IRA has not been contributed to in years.

Let's say we convert $5,000 from the traditional to Roth this year.

Do I have to know anything more complex than the fact that we have an additional $5,000 of taxable income this year?
OP

read this: https://www08.wellsfargomedia.com/asset ... a-rule.pdf

https://www.irs.gov/retirement-plans/ro ... ment-plans

look at this booklet: https://www.irs.gov/pub/irs-pdf/p4530.pdf
Last edited by retire2022 on Wed Dec 01, 2021 12:53 pm, edited 1 time in total.
tibbitts
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by tibbitts »

PA86 wrote: Wed Dec 01, 2021 12:39 pm I'm a little confused about deductible and non deductible funds.

I'm unclear about the "we" and "fiance" and "she is in the <whatever> bracket" and "we will pay taxes" and "our holdings." So this is MFJ or... ?

About the whole "fiance" vs. "fiancee" thing: it seems like an alternative sex-neutral term would be handy.
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PA86
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by PA86 »

Unmarried, we are both single filers.
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retiredjg
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by retiredjg »

PA86, it is critical to determine if she has made any non-deductible contributions to her tIRA at any time in the past. If she has, the Roth conversion will be pro-rated between the not-yet-taxed money and the already-taxed money.

That is step one.

If she does the conversion, the brokerage will issue a 1099 and that is entered into tax software like any other 1099. The software should also generate a Form 8606, Part II to report that this income is from a Roth conversion.

If there are non-deductible contributions in the IRA, it gets more complicated.
Silk McCue
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by Silk McCue »

PA86 wrote: Wed Dec 01, 2021 12:52 pm Unmarried, we are both single filers.
If you are getting married shortly, I would consider waiting to take advantage of the wider brackets for MFJ to possibly save on taxes.

Cheers
tibbitts
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by tibbitts »

Silk McCue wrote: Wed Dec 01, 2021 1:37 pm
PA86 wrote: Wed Dec 01, 2021 12:52 pm Unmarried, we are both single filers.
If you are getting married shortly, I would consider waiting to take advantage of the wider brackets for MFJ to possibly save on taxes.

Cheers
Wider brackets but possibly higher marginal rates depending on how the income and brackets work out. Ultimately the OP needs to first figure out whether a conversion makes sense either now or later with either filing status.
Parkinglotracer
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by Parkinglotracer »

As stated in previous threads there may be “covid economic” tax credits to be had filing 2021 taxes if your income is less than XX dollars

For a MFJ couple the credit is for income less than 150K income.

Don’t rule out the free money when planning Roth conversions
an_asker
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by an_asker »

PA86 wrote: Wed Dec 01, 2021 12:39 pm I'm a little confused about deductible and non deductible funds.

The traditional IRA has not been contributed to in years.

Let's say we convert $5,000 from the traditional to Roth this year.

Do I have to know anything more complex than the fact that we have an additional $5,000 of taxable income this year?
OK, deductible and non deductible was how the monies went in. Say, she put in some money pre-tax (because at that point in time, her income was below the limit and she was able to do so) and then she put in some money post-tax. [needless to say, I am referring to multiple years of contributions here]

I am assuming that the brokerage would have the proportional splits of the current balances. Maybe retiredjg might have a better answer as to how the prorating is done, but I would assume that the prorating is based on the pre-tax vs post-tax ratio. What I am not sure about is whether (and what) she would also need to pay as taxes for the growth in the post-tax amount.

For instance, let's say she converts $5k. Of this, $4k is post-tax and $1k is pre-tax (by ratio). She would need to pay taxes on the entire $1k pre-tax for sure. What I am not sure is how much - if any - taxes she needs to pay on the $4k if I arbitrarily assume that she had put in $2k a few years back which has now doubled to $4k.
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retiredjg
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by retiredjg »

PA86, this seems like one of those many threads posted lately by someone who is trying to do a big last minute Roth conversion in anticipation of the thing-that-cannot-be-discussed and which may not even happen.

There should be a very good reason to do a conversion of this magnitude (unemployed for the year or something like that)....in my opinion. Single people are already in high brackets just because they are single. This might be a move that needs more consideration.
tibbitts
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by tibbitts »

an_asker wrote: Wed Dec 01, 2021 3:43 pm
For instance, let's say she converts $5k. Of this, $4k is post-tax and $1k is pre-tax (by ratio). She would need to pay taxes on the entire $1k pre-tax for sure. What I am not sure is how much - if any - taxes she needs to pay on the $4k if I arbitrarily assume that she had put in $2k a few years back which has now doubled to $4k.
The only issue is how much was contributed that taxes were already paid on - it's the tax basis in the account. It would have to be on the 8606 filing from the last year she contributed to an IRA but couldn't deduct the entire contribution (assuming no withdrawals since then.)
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retiredjg
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by retiredjg »

an_asker wrote: Wed Dec 01, 2021 3:43 pm I am assuming that the brokerage would have the proportional splits of the current balances.
Unfortunately, the split between pre-tax and post-tax is known only to the tax-payer (if they keep records) and the IRS. The brokerage does not know if a contribution is deducted or not.
an_asker
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by an_asker »

retiredjg wrote: Wed Dec 01, 2021 3:56 pm
an_asker wrote: Wed Dec 01, 2021 3:43 pm I am assuming that the brokerage would have the proportional splits of the current balances.
Unfortunately, the split between pre-tax and post-tax is known only to the tax-payer (if they keep records) and the IRS. The brokerage does not know if a contribution is deducted or not.
Oh ok. Hypothetical question here.

Let's assume investor is smart and, to assist in separating them, kept the buckets separate by purchasing different indices in the two. (I don't even know if this is permitted or if the entire account is split by ratio of inputs)

Pre-tax contribution = $1000
Post-tax contribution = $4000
Ten years later.
Pre-tax contribution has gone to $4000
Post-tax contribution has gone to $8000

Now, if $3000 is converted to Roth, how is the pro-rata split determined?
1:2 pre-tax to post-tax (based on current split), OR
1:4 pre-tax to post-tax (based on split when the monies went into the account)?

Next, I understand that all of the pre-tax will be taxable. But what part of the post-tax will be taxable (I assume it will be the difference between post-tax portion and what it's corresponding value was when invested) and at what rate? In other words, would this be the marginal tax bracket or the capital gains rate? I am assuming marginal tax bracket, but I am not sure.

PS: Just curious. I am trying my best to avoid this scenario!!
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Chip Munk
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by Chip Munk »

an_asker wrote: Wed Dec 01, 2021 7:53 pm Oh ok. Hypothetical question here.

Let's assume investor is smart and, to assist in separating them, kept the buckets separate by purchasing different indices in the two. (I don't even know if this is permitted or if the entire account is split by ratio of inputs)

Pre-tax contribution = $1000
Post-tax contribution = $4000
Ten years later.
Pre-tax contribution has gone to $4000
Post-tax contribution has gone to $8000

Now, if $3000 is converted to Roth, how is the pro-rata split determined?
1:2 pre-tax to post-tax (based on current split), OR
1:4 pre-tax to post-tax (based on split when the monies went into the account)?

Next, I understand that all of the pre-tax will be taxable. But what part of the post-tax will be taxable (I assume it will be the difference between post-tax portion and what it's corresponding value was when invested) and at what rate? In other words, would this be the marginal tax bracket or the capital gains rate? I am assuming marginal tax bracket, but I am not sure.

PS: Just curious. I am trying my best to avoid this scenario!!
When you say "Ten years later, Post-tax contribution has gone to $8,000", do you mean it has appreciated or that an additional $4,000 has been contributed? If you mean the former, then the basis is still $4000 -- the total amount of post-tax contributions made to the IRA. Any growth on that $4,000 is untaxed money, so it's subject to tax when withdrawn.

In that case, given the value of the IRA has grown to $12,000 (see note below) if you do a Roth conversion, the non-taxable percentage is determined by dividing the basis by the total value of the IRA. In this example that would be 4,000 / 12,000 = 33.33%. So if you convert $3,000, then $1,000 is not taxable, $2,000 is taxable. You then reduce your basis by the amount of post-tax funds withdrawn from the IRA so the basis would then become $3,000.

That calculation is done each year you make withdrawals/conversions, each time reducing the basis by the amount of non-taxable money that is withdrawn.

Note: the total value of the IRA to use for this calculation is based on the value at the end of the tax year in which you made the withdrawal/conversion. The calculation is done on IRS Form 8606. If you look at that form, you will see you take the value of the IRA at the end of the year, you add back in the amount of the conversion and that becomes the denominator when determining how much is taxable/non-taxable.

If by "Post-tax contribution has gone to $8,000" you mean another $4,000 in post-tax money is added to the IRA, then the Basis would be $8,000 and the initial conversion non-taxed percentage would be 8000/12000 = 66.66%.
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retiredjg
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by retiredjg »

an_asker wrote: Wed Dec 01, 2021 7:53 pm
retiredjg wrote: Wed Dec 01, 2021 3:56 pm
an_asker wrote: Wed Dec 01, 2021 3:43 pm I am assuming that the brokerage would have the proportional splits of the current balances.
Unfortunately, the split between pre-tax and post-tax is known only to the tax-payer (if they keep records) and the IRS. The brokerage does not know if a contribution is deducted or not.
Oh ok. Hypothetical question here.

Let's assume investor is smart and, to assist in separating them, kept the buckets separate by purchasing different indices in the two.
This does not work (and it would limit what you can do with your money for decades). Your basis is not tied to what you invested it in. Your basis is exactly equal to the number of after-tax dollars you put in the account.

In your example, your basis is $4k at the beginning of the 10 year period and $4k at the end of the 10 year period. During that 10 years you can sell and buy as many times as you want without changing the basis.

You will not pay tax on that basis again if you sent documentation to the IRS (and kept a copy for yourself) that the $4k was a non-deductible contribution.

As you empty the IRA(s) you will pay tax on all the other dollars in the IRA(s). If you empty it at the end of 10 years, you will pay tax on exactly $8k ($12k total minus $4k basis). If you take several years to empty the IRA, what you take out will always be a pro-rated amount. This continues until the IRA is empty.
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by Wiggums »

In my state, I pay federal and state taxes on a Roth Conversion.
"I started with nothing and I still have most of it left."
an_asker
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by an_asker »

retiredjg wrote: Thu Dec 02, 2021 7:06 am
an_asker wrote: Wed Dec 01, 2021 7:53 pm [...]
Oh ok. Hypothetical question here.

Let's assume investor is smart and, to assist in separating them, kept the buckets separate by purchasing different indices in the two.
This does not work (and it would limit what you can do with your money for decades). Your basis is not tied to what you invested it in. Your basis is exactly equal to the number of after-tax dollars you put in the account.

In your example, your basis is $4k at the beginning of the 10 year period and $4k at the end of the 10 year period. During that 10 years you can sell and buy as many times as you want without changing the basis.

You will not pay tax on that basis again if you sent documentation to the IRS (and kept a copy for yourself) that the $4k was a non-deductible contribution.

As you empty the IRA(s) you will pay tax on all the other dollars in the IRA(s). If you empty it at the end of 10 years, you will pay tax on exactly $8k ($12k total minus $4k basis). If you take several years to empty the IRA, what you take out will always be a pro-rated amount. This continues until the IRA is empty.
Oh got it. So the calculations are probably less crazy than I had first assumed.
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Chip Munk
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by Chip Munk »

an_asker wrote: Thu Dec 02, 2021 9:32 am Oh got it. So the calculations are probably less crazy than I had first assumed.
I use Turbo Tax and when it fills out Form 8606, it also carries over the updated basis from year to year. You can always find it by looking at the IRA Worksheet. If you save a copy of your return as a PDF and include key worksheets, the IRA Worksheet will be in that PDF.

One thing I forgot to mention in my reply above is that you need to know how your state treats IRA contributions. I live in Massachusetts and it does not allow a deduction for an IRA contribution even if you are able to deduct it on your federal tax return. It also does not allow you to deduct contributions to a SEP-IRA if you are the business owner. So even if someone never made a post-tax contribution to an IRA from a federal tax perspective, every contribution to a T-IRA and possibly also a SEP-IRA is post-tax from a state tax perspective and you need to track your state basis. Massachusetts also treats withdrawals/conversions differently in that your basis comes out first until exhausted, then your pre-tax money (the earnings).

I wish I had understood this back when I first started contributing to an IRA because I would have kept track of my contributions along the way. Fortunately I was able to reconstruct everything from old tax records and brokerage statements that I had kept.
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by jimcrawford01 »

OP
Best advice - Get up close and personal with IRS Form 8606 and Instructions!!!
Consider EACH line and work to understand the what and why.
Do a few practice runs.
If you still do not understand, then repeat! After a few iterations, you will start to understand and it becomes a LOT easier.
If not willing to do the work, pay someone to do it for you.
Jim
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by Walkure »

tibbitts wrote: Wed Dec 01, 2021 12:49 pm About the whole "fiance" vs. "fiancee" thing: it seems like an alternative sex-neutral term would be handy.
I propose (pun intended) that the word “betrothed” would answer nicely for this purpose.
tibbitts
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by tibbitts »

Walkure wrote: Thu Dec 02, 2021 5:08 pm
tibbitts wrote: Wed Dec 01, 2021 12:49 pm About the whole "fiance" vs. "fiancee" thing: it seems like an alternative sex-neutral term would be handy.
I propose (pun intended) that the word “betrothed” would answer nicely for this purpose.
Excellent! Bonus for Bogleheads: less easily confused with "finance."
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by an_asker »

I've a question that's OT (in the sense that OP might not care about the answer). And I confess, I kinda screwed up in my own conversion I think... not a big deal but maybe a swing of $200 either way. :oops:

For some reason, I assumed that if I transfer/convert a mutual fund holding from an IRA to a Roth IRA, the transfer will happen only at the end of the day. However, I found out I was wrong and the fund instantaneously transferred. So, if the transfer occurred (at noon) say on a Wednesday, would I get a tax bill (form 8606) based on Tuesday's price or Wednesday's price of the mutual fund?
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by Eagle33 »

an_asker wrote: Sun Dec 05, 2021 9:59 pm I've a question that's OT (in the sense that OP might not care about the answer). And I confess, I kinda screwed up in my own conversion I think... not a big deal but maybe a swing of $200 either way. :oops:

For some reason, I assumed that if I transfer/convert a mutual fund holding from an IRA to a Roth IRA, the transfer will happen only at the end of the day. However, I found out I was wrong and the fund instantaneously transferred. So, if the transfer occurred (at noon) say on a Wednesday, would I get a tax bill (form 8606) based on Tuesday's price or Wednesday's price of the mutual fund?
taxes will be based on the actual $ amount that was transferred from tIRA to Roth IRA. Go look at the settled transaction in your Roth IRA to see the actual dollar amount for the shares you transferred and divide the $ by share qty to get the price.
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by an_asker »

Eagle33 wrote: Mon Dec 06, 2021 2:30 pm [...]
taxes will be based on the actual $ amount that was transferred from tIRA to Roth IRA. Go look at the settled transaction in your Roth IRA to see the actual dollar amount for the shares you transferred and divide the $ by share qty to get the price.
But a $ amount was not transferred. I transferred shared in kind - from Rollover IRA to Roth IRA. I will call Fidelity tonight ...
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Re: Roth Conversion for Dummies (I don't know how to do taxes!)

Post by tibbitts »

an_asker wrote: Mon Dec 06, 2021 3:13 pm
Eagle33 wrote: Mon Dec 06, 2021 2:30 pm [...]
taxes will be based on the actual $ amount that was transferred from tIRA to Roth IRA. Go look at the settled transaction in your Roth IRA to see the actual dollar amount for the shares you transferred and divide the $ by share qty to get the price.
But a $ amount was not transferred. I transferred shared in kind - from Rollover IRA to Roth IRA. I will call Fidelity tonight ...
But the transaction, once completed, will have a dollar value - that dollar value is displayed and is all that matters at this point.
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