I'm frequently asked, "If you have an IRA with a portion that is nondeductible, isn't that nondeductible portion excluded from being taxed when converted?" This question comes up when a contribution to an IRA was not tax deductible on your tax return. This happens because the individual had high income and contributed to a 401(k) plan at work and an IRA account (phase out rule) in the same year.
In this case, we say the amount that was nondeductible is the "basis" of the IRA. Upon withdrawal, you will not pay income tax on the basis since you have already paid income tax when you invested the money. However, you will pay income tax on any of the gains. If you have an IRA that was nondeductible (has basis) and an IRA that was deductible, you treat them as one IRA when converting or withdrawing, even if you know which one has the basis. This is referred to as a "commingled" account.
Whether you convert or withdraw a partial amount from your IRA with basis, you must allocate the basis to the portion that is being withdrawn. If the conversion is a full conversion of all the IRA accounts, then you would subtract the basis from the total conversion and you would pay income tax on the net amount. To determine how much is tax-free in a partial withdrawal or conversion, you take the basis and divided that by the sum of all the IRA account values as of the last day of the year of conversion. This will be your tax-free percentage. Then you multiply that percentage by the conversion amount and that will be the tax-free portion of the IRA. Next, you subtract the tax-free portion from the conversion amount and this total is the taxable amount to be added to your income.
For example, let's say you converted $10,000 into a Roth IRA in 2010. The IRA that you converted has a basis of $20,000 and on December 31, 2010, the value of all of your IRA accounts (not counting the Roth IRA conversion value) was $100,000. To determine the taxable portion, you will divide the $20,000 basis into $110,000 ($100,000 IRA value at year-end plus the $10,000 that was converted), which equals 18.19 percent (percentage of your basis). Then multiply the 18.19 percent by the $10,000 that was converted; equaling $1,819. This $1,819 is the tax-free portion of the conversion. The remaining $8,181 ($10,000 less $1,819) will be the taxable income. Keep in mind, this percentage will change each year, depending on the total value of all of your IRA accounts.
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