If you did a Roth individual retirement account conversion in 2022, you could have a more complicated tax return this season, experts say.
strategy, which moves the pretext or non-deductible ira Funding Roth IRAs for future tax-free growth becomes more popular during a stock market crash Because you can convert more properties for less dollar amount. While the trade-off is the advance tax, your income may be reduced by converting to lower-value investments.
“You get more bang for your buck,” said Jim Guarino, a certified financial planner and managing director at Baker Newman Noyes in Woburn, Massachusetts. He is also a Certified Public Accountant.
More from Personal Finance:
IRS says tax season opens for individual filers on January 23
Here are 3 key moves to make before 2023 tax filing season opens
After ‘misery’ for tax filers in 2022, IRS to ramp up 2023 tax season, says taxpayer advocate
If you completed a Roth conversion in 2022, you would receive Form 1099-R From your custodian, that includes distributions from your IRA, Guarino said.
You will need to report the transfer Form 8606 It’s up to you to tell the IRS what portion of your Roth conversion is taxable, he said. However, when pretax and non-deductible IRA contributions mix over time, the calculation can be trickier than you might expect. (If you don’t qualify for full or partial tax breaks due to income and workplace retirement plan participation, there may be non-deductible contributions to your pretax IRA.)
“I see a lot of people making mistakes here,” Guarino said. The reason is the so-called “pro-rata rule” that requires you to include your total pretax IRA funds in the calculation.
How does the law of proportion work
Joan May, a CFP and CPA with Forest Asset Management in Berwyn, Illinois, said the pro-rata rule is the equivalent of adding cream to your coffee, then discovering that you can’t remove the cream once it’s poured.
“That’s exactly what happens when you mix pretax and non-deductible IRAs,” she said, meaning you can’t easily convert the after-tax portion.
For example, let’s say you have a pretax IRA of $20,000 and you make a non-deductible IRA contribution of $6,000 in 2022.
If you converted the entire $26,000 balance, you would divide $6,000 by $26,000 to calculate the tax-free portion. This means that about 23% or about $6,000 is tax-exempt and $20,000 is taxable.
Alternatively, let’s say you have $1 million in some IRA and make non-deductible contributions of $100,000, or 10% of the total. If you convert $30,000, only $3,000 will be non-taxable and $27,000 will be taxable.
Of course, the larger your pretax IRA balance, the higher percentage of the conversion that’s taxable, May said. Alternatively, a large non-deductible or Roth IRA balance reduces the percentage.
But here’s the kicker: Taxpayers use Form 8606 to report non-deductible IRA contributions each year to establish “basis,” or your after-tax balance.
However, after several years, it’s easy to lose track of Aadhaar even in professional tax software, May cautioned. “It’s a big problem,” she said. “If you miss it, you’re basically paying tax twice on the same money.”
Conversion time to avoid ‘unnecessary’ tax collision
with him S&P 500 Still down nearly 14% over the last 12 months through Jan. 19, you may be eyeing a Roth conversion. But tax experts say you need to know your 2023 income to figure out the tax consequences, which can be difficult at the beginning of the year.
“I recommend waiting until the end of the year,” said Tommy Lucas, a CFP and enrolled agent at Moisand Fitzgerald Tamayo in Orlando, Florida, noting that income can change from factors such as selling a house or year end mutual fund distribution,
Typically, their goal is to “fill the lower tax brackets” without bumping someone into the next one with Roth conversion income.
For example, if a client is in the 12% bracket, Lucas may limit conversions to avoid spilling over into the 22% tier. Otherwise, they would pay more on taxable income in that higher bracket.
“The last thing we want to do is throw someone into an unnecessary tax bracket,” he said. and increasing income may have other consequences, such as reducing eligibility for certain tax exemptions or Higher Medicare Part B and D premiums,
Baker Newman Noyes’s Guarino also crunches the numbers before making a Roth conversion decision, noting that he’s “essentially doing Form 8606 calculations during the year” to figure out how much taxable income the Roth conversion will generate. .