There is one important rule to keep in mind when it comes to converting a traditional IRA to a Roth IRA – you need to pay federal income taxes on any portion of the conversion that you haven’t already paid taxes on.

Example 1

For example, let’s say you started to fund traditional IRAs in 2006 and by 2010 you’ve got $20,000 in your account.  Furthermore, let’s say this account consisted of four years of $4,000 non-deductible contributions – a total of $16,000 in non-deductible contributions and $4,000 in account growth.

In this example, you’d need to pay income taxes on the $4,000 in fund growth when you convert to a Roth IRA.  But the good news is you’ll never have to pay income taxes on this account again.

Example 2

In this second example, let’s assume that you funded the that same traditional IRA with before-tax dollars – meaning you were able to take a deduction on your tax return for the money placed in the traditional IRA.

In this example, you haven’t paid income taxes on any of the money in the account, so when you convert it to a Roth IRA taxes are owed on the entire account balance.  In this case you’d have to pay income taxes on all $20,000 in your fund.

Example 3

If you have an existing traditional IRA (with tax-deductible contributions) and you start to fund a non-deductible IRA, then you need to be aware that tax rules state that any conversion is done on a pro-rata basis.  Let’s say you had $100,000 in a regular IRA and you had $25,000 in a non-deductible IRA.

If you wanted to convert $25,000 to a Roth, then you’d owe taxes on $20,000 because the pro-rata share of your non-deductible contributions is only $5,000.

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