I recently read your discussion of the rules for converting money in a traditional IRA to a Roth. I realize that most people deduct contributions to their traditional IRA and, upon converting to a Roth, they must pay taxes on those contributions. But what about nondeductible contributions you make to a traditional IRA?
You’re right that the tax situation is very different depending on how you’ve made your contributions. If all of your IRA contributions are tax-deductible, then the calculation is simple: The entire conversion is taxable. But if some of your contributions are nondeductible, the calculation gets trickier. In that case, you don’t have to pay taxes on the portion of the conversion that was from nondeductible contributions because you have already paid taxes on that money.
But you can’t cherry-pick which money to convert. If you convert only part of the money in your IRAs, the tax bill is based on the ratio of your nondeductible contributions to the total balance in all of your traditional IRAs. If, for example, you made $2,000 in nondeductible contributions and you have $10,000 in your traditional IRAs, then 20% of your conversion would be tax-free.
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It’s also important to keep this rule in mind if you earn too much to contribute to a Roth IRA and want to make a nondeductible contribution to a traditional IRA and immediately convert it to a Roth (see Getting Around Income Limits for a Roth IRA). If it is your only contribution to a traditional IRA, you’ll pay taxes only on the earnings between the time of the contribution and the conversion. But if you’ve made tax-deductible contributions to an IRA, then the tax-free portion of the conversion is based on the ratio of your nondeductible contributions to your total IRA balance.
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