When you convert a traditional IRA to a Roth IRA, you pay income tax now but expect tax-free withdrawals in the future. However, many taxpayers overpay: they pay income tax on dollars that already have been taxed.
Suppose Jim Nelson has $100,000 in his traditional IRA. That includes $20,000 of nondeductible, aftertax contributions. Suppose that Jim converts the entire traditional IRA to a Roth IRA.
Instead of paying tax on $100,000 of income, he should pay tax on only $80,000. That’s the amount of untaxed dollars in the account. Some people, though, will pay tax on the entire $100,000, and thus overpay by 25%.
What if Jim wants to convert only $40,000 of his traditional IRA to a Roth IRA? No matter how much he converts, the conversion will be 80% taxable and 20% tax-free. Jim should keep track of the aftertax dollars in his traditional IRA so he can pay the proper amount of tax on any future Roth IRA conversions.
If you’re thinking of a Roth IRA conversion, check your past tax returns to see if you have filed Form 8606. This form will show your aftertax IRA contr
