Do I have to pay tax on this Roth IRA conversion?

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Dear Dan,

I made a $7,000 nondeductible contribution to my IRA account in 2000 and 2001. If I convert exactly these $14,000 to Roth IRA this year, do I have to pay any tax?

Dear reader,

Yes, you will probably owe tax on a conversion of $14,000. You cannot just convert the $14,000 of nondeductible contributions. The taxation is done on a pro rata basis applied to ALL your personal IRA funds IRAs.

Example: You have an $86,000 IRA that is comprised of all pretax money and a second IRA worth $14,000, funded by the two $7,000 nondeductible contributions you describe. You then send the $14,000 to a Roth IRA by filing conversion paperwork with the company holding that $14,000 IRA. 

The tax calculation prorates the nondeductible contribution over the total balance of ALL your non-Roth IRAs. The total of ALL your IRAs is $100,000. Therefore, assuming those were your only nondeductible contributions to any of your IRAs, only 14% ($14,000/$100,000) of any conversion (and most distributions) is deemed after-tax money.

This is all tracked and accounted for on Form 8606 using the balance of all your IRAs on Dec. 31 of the year you made the conversion. You should have reported the nondeductible contributions on a Form 8606 each year you made those contributions.

So, in your case, a $14,000 conversion results in a 1099-R for $14,000 coded as a conversion. You will report the $14,000 on line 4a “IRA distributions”, and $12,040 on line 4b “Taxable amount.” You will adjust the basis in the IRA on form 8606. (The after-tax money is called “basis.”) Because 14% of the $14,000 converted was basis, you no longer have $14,000 in basis. You reduce the $14,000 original basis by the $1,960 (14% of the conversion) used and are left with $12,040 of basis to be used against part of your any conversion or noncharitable distribution made in future tax years.

All that said, your record-keeping, or your description seems off to me. I hope you just typed in the wrong years or wrong amount. Otherwise, you may have a problem. The limit for an IRA contribution in 2000 and 2001 was just $2,000. 

If you actually made $7,000 contributions, you made “excess contributions” of $5,000 in each year. The penalty for that is 6% of the excess per year for each year the excess remains in the IRA. I won’t go into process to correct that here, but will point out you also must remove earnings attributable to the excess contributions. Those distributed earnings will be taxable. Given it has been more than 20 years, the penalties, applicable interest on unpaid amounts, and tax bill could be significant. You will need a tax adviser to help you get this straight.

Looking forward, if you get your Form 8606 up-to-date, are still working and have a qualified retirement plan like a 401(k) or 403(b), you may be able to convert just the after-tax money bit only after a few maneuvers. Check with your employer to see if the plan accepts rollovers from IRAs. If it does, you can roll all of your IRA money except an amount equal to your basis in your IRAs into the plan. Plans cannot accept after-tax funds in rollover so you should be asked to sign an affidavit affirming all of the funds rolled in are pretax.

Once those pretax funds are in the employer plan, all that is left is after-tax money. These after-tax fuds can then be converted with no additional tax. Just make sure the balances of all of your IRAs is $0 on Dec. 31 of the year in which you make the conversion. Do not roll the money out of the 401(k) into an IRA that Dec. 31.

If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line. 

Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving clients nationwide from offices in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some reader questions are edited to aid the presentation of the subject matter.