taxes

Converting a traditional IRA to a Roth IRA

George SaenzQuestionDear Tax Talk,
I have a traditional IRA that has before-tax contributions and after-tax contributions. If I switch to a Roth IRA this year, it is my understanding that I do not have to pay taxes on the portion attributed to the after-tax contribution. How does this get reported? By using a 1099? How do I report it properly on my taxes?
-- Mark K.

AnswerDear Mark,
Traditional IRA contributions come in two flavors: deductible and nondeductible. A traditional IRA is the original IRA that was started way back in the '70s. It is labeled "traditional" to distinguish it from a Roth IRA. The amount you can contribute is the same, but the deductibility of the contribution depends on various factors.

Many people are reluctant to establish an IRA in which the contributions are not deducted. Distributions from an IRA are ordinary income, so if you can't deduct the contribution, you may be better off investing in stocks or other equities that are taxed at preferential long-term capital gains rates.

To designate contributions as nondeductible, you must file Form 8606. If you do not report nondeductible contributions, all of the contributions to your traditional IRA will be treated like deductible contributions when withdrawn. All distributions from your IRA will be taxed unless you can show, with satisfactory evidence, that nondeductible contributions were made.

When you convert a traditional IRA to a Roth IRA, you're basically electing to pay tax now in hopes that future growth in the IRA will come back to you tax-free. Many people did this prior to the market crash and wound up on the short end of the stick: They paid tax on more money than is in their account now. If only they knew then what they know now.

If you're still willing to live with the risks, you're absolutely right that you will not being paying tax on your nondeductible contributions. In fact, it may be a good opportunity for folks with nondeducted IRAs to convert to a Roth IRA.

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To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

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