There is a hidden gotcha for all people who opened a
non-deductible IRA in 1997 and then convert it to a Roth
IRA in 1998. Most likely you will owe taxes on the
non-deductible amount even though you paid taxes on the
non-deductible amount in 1997 and even if the non-deductible
amount didn't have earnings. The following information from
Vanguards web site at "http://www.vanguard.com" explains why.
What if I open a traditional IRA with a nondeductible
contribution in 1997 and then convert it in 1998? If it had
no earnings, I wouldn't have any tax liability, would I?
The IRS does not allow you to designate only nondeductible
IRA assets for conversion. A conversion is considered a
prorata distribution from the nondeductible and deductible
contributions and earnings in all your IRAs. Thus, your tax
liability is based on the balance of all your IRAs.
What does the law mean by "the balances of all your IRAs"?
This means that you must consider the balances of all
traditional IRAs and rollover IRAs (also known as conduit
IRAs) in the calculation. The balances of 403(b) plans and
qualified plans, such as 401(k) plans, are not included for
this purpose.
How do I determine what percentage of my conversion is
taxable?
IRS Form 8606-Nondeductible IRAs (Contributions,
Distributions, and Basis)-is used both for reporting
nondeductible contributions and for determining the taxable
amount of your distributions if you have made nondeductible
contributions. Because a conversion is considered a
distribution from a traditional IRA and a rollover
contribution to the Roth IRA, you would use IRS Form 8606
to figure the taxable portion of the conversion. The form
uses a fairly simple formula. Form 8606 can be downloaded
at the IRS website.
I have made both deductible and nondeductible contributions
to my traditional IRAs. Can I elect to convert only the
nondeductible portion so I can avoid taxes on the
conversion?
No. As with any other traditional IRA distribution, if you
have made both deductible and nondeductible contributions,
each distribution is treated as a proportionate
distribution of nondeductible contributions and deductible
contributions and earnings. You may not identify a
distribution as a return of a nondeductible contribution
only.
c 1998 Vanguard Marketing Corporation, Distributor
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