Here’s a Q&A from timesunion.com:
JC writes: “I earn more than IRS rules permit to directly contribute to a Roth IRA. If I contribute $5000 to an already established non-deductible IRA Money Market Fund held by Vanguard then the next day roll it to my Vanguard Roth Money Market, what, if anything, needs to be reported on my tax return? The Traditional IRA Money Market Fund had a $.01 balance and all $5,000 was rolled.”
Roth IRA rules now permit anyone to convert from a traditional IRA to a Roth, irrespective of income. JC’s letter shows how a conversion can be done without triggering a tax.
Keep in mind that Roth IRAs are tax-free retirement vehicles, not tax deferred, in contrast to traditional IRAs. That means that if you abide by the rules (the subject of a later column), your earnings and gains will not be taxed while you have the Roth, and you can withdraw money without triggering a tax.
Unlike traditional IRAs, Roths do not have minimum distribution requirements after age 70-1/2.
Because a conversion works like a rollover, JC will receive a Form 1099 from Vanguard that will show the $5,000 distribution from his IRA. But, since the entire $5,000 is a non-deductible contribution (“basis”), no income tax is triggered on the conversion.
Let’s assume that JC contributes to his 2013 traditional IRA on May 1, 2013, and converts on May 2. He will fill out an IRS Form 8606, which he will file with his 2013 tax return.
That form gives JC a record of his IRA basis — the non-taxable amount of the distribution — in this case $5,000. He will note the $5,000 on Part I of IRS Form 8606 (Nondeductible IRAs), which he has to attach to his tax return for 2013. He will also record his $5,000 conversion to the Roth on the form in Part II. Item 18 shows the taxable amount, which will be zero in this case ($5,000 less $5,000). You can find the form on page 46 of Publication 590 2012 or download it from the IRS website, irs.gov.
JC will also receive an IRS Form 5498 from Vanguard later in the year showing the amount of the conversion to be $5,000. The form is also sent to the IRS.
As a general rule, you’ll want to seriously consider converting some or all of your traditional IRAs to Roths when you have basis — that is, you’ve made non-deductible contributions over the years. The reason is very simple. Your basis is not taxable. Your IRA value above your basis is taxable.
Roth IRAs are great options, especially for younger savers. If you don’t have one, you’re missing out on serious tax benefits. For more information about this and anything else retirement planning related, contact the tax experts at the IRA Financial Group today!