If you are ineligible to contribute directly to a Roth IRA you may have elected to instead fund a Traditional IRA – with the intention of subsequently converting to a Roth IRA. It’s important to understand how these transactions should be reported on your tax return.
Step 1: Record the after-tax Traditional IRA contribution
When you make an after-tax contribution to a Traditional IRA the contribution should be recorded on IRS Form 8606. It’s as simple as indicating the amount on Line 1 of the form.
Line 4 should also be completed in the event contributions were made after January 1st for the prior tax year.
Note that the purpose of this form is not to claim a deduction on your tax return. Pre-tax Traditional IRA contributions are recorded on the 1040 to reduce your taxable income. After-tax contributions are not shown on the 1040 but are instead recorded on Form 8606.
What is the importance of Form 8606?
Essentially Form 8606 tracks your aggregate after-tax Traditional IRA contributions for a single purpose: to ensure that upon distribution the funds are not taxed a second time.
Step 2: The Conversion
If you convert funds from a Traditional IRA to a Roth IRA you’ll receive a 1099-R from the custodian of your IRA.
It will look like this:
Let’s review four items on this 1099-R.
- Box #1: This is the total amount distributed from your Traditional IRA and converted into your Roth IRA. In this example the individual contributed $6,000 to their Traditional IRA, earned 51 cents of earnings and then converted to their Roth IRA.
- Box #2a: This box is both confusing and often concerning. It seems to indicate that the amount in box 2a is subject to taxation. That’s not the case! If you read the IRS instructions, you’ll see the amount in box 2a is “generally taxable,” but not always taxable!
- Box #2b: This is important. Given that we just clarified that box 2a is “generally (but not always!) taxable,” it is box 2b that confirms that our custodian (Schwab in this case) is not able to determine the taxable amount. More on this below.
- Box #7: The distribution code of 2 means that a distribution was taken before age 59 ½ but an exception from the usual 10% premature withdrawal penalty applies. This is consistent with our understanding that Roth IRA conversions are not subject to a 10% penalty regardless of age.
Step #3: Determine Your Basis
We’ve established that the 1099-R by itself will not be particularly helpful in determining the taxable amount of the conversion.
The 1099-R really really only tells us the amount distributed (box #1). You should also note that because the amount is box #2 is generally taxable, the IRS is going to assume it is taxable. To the extent possible, we need to prove otherwise.
We’ll now see the importance of accurately completing Form 8606.
Form 8606 is going to track your aggregate after-tax Traditional IRA contributions. The IRS refers to this as basis. If you just started an IRA and contributed $6,000, the basis is $6,000. If you contributed $6,000 twice (for two separate tax years), the basis would be $12,000. If you’ve funded an IRA for years but converted in the past, note that the basis changed when you last converted.
Accurately calculating your basis is so important that the IRS even bolds the applicable line on Form 8606:
The basis has to be entered correctly! Otherwise a hairy mess awaits – and likely double taxation to boot.
Step 4: Determine the Taxable Amount
If the basis is entered correctly, the taxable amount of your Roth conversion can be calculated rather easily.
There is just one trap to be aware of before we finish this exercise.
The IRS is going to ask for the value of all of your IRAs at year-end. Again, the IRS uses bold font to stress the importance of this so I will too! You cannot determine the taxable amount of a single IRA in isolation. You have to consider the value of all of your IRAs in the process. Note this does not include your Roth IRA. This includes Traditional, SEP and SIMPLE IRAs. I hope you were aware of this consideration before converting. Otherwise it may be an expensive surprise.
For this post I’m going to conveniently assume that value of all your IRAs at year-end was $0. If so, we can quickly move to Part II of Form 8606.
The individual in our example will enter the amount of the Roth conversion ($6,001 due to rounding) on line 16.
Then they will pull the amount to be entered on line 17 from line 11 of Part I. Note that the line numbers change from year-to-year as forms are modified.
Now you can see how important it was to track the basis. The taxable amount – as determined by Form 8606 and NOT by the 1099-R is the difference between the amount converted ($6,001) and the basis ($6,000). Thus the tax liability is just $1. Much better than the $6,001 seemingly suggested by the 1099-R.
The articles presented on this blog are general in nature and should not be assumed to be applicable to your situation. In addition, tax law changes daily and the articles on this blog are not updated to reflect these changes. Anyone receiving any part of the information on this blog should not rely on or act or refrain from acting on the basis of any matter or information contained in this blog without seeking appropriate tax, legal or other professional advice. The transmission and receipt of information contained on this blog does not form or constitute a client relationship. Nothing in this blog constitutes legal advice. Opinions rendered by tax professionals are not authority. You agree to hold Brendan Willmann, CFA, CFP®, CPA, EA, forever harmless from any liability for your use or failure to use the information, advice, referrals, or suggestions provided by this blog at any time.