- Deductible contributions. These are contributions that are deducted from your taxable income for the tax year in which the contributions were made.
- Nondeductible contributions. Any contribution for which you do not take a tax deduction is known as a nondeductible contribution. Such contributions create what is sometimes called "basis" in your traditional IRA.
Your tax liability is based on 2 things:
- the taxable income generated by the conversion, and
- your applicable tax rate.
Estimating the taxable income from a conversion is straightforward if you've never made nondeductible contributions to any traditional IRA. If that is the case, whatever amount you convert will all be taxable income.
Note that earnings are always taxable when converted, whether they come from deductible or nondeductible contributions, so for purposes of figuring out taxes on a conversion, you can think of your balances as falling into just 2 categories:
- nondeductible contributions, and
- everything else
According to IRS rules, you cannot cherry-pick and convert just nondeductible contributions, leaving deductible contributions and earnings in the account, in order to avoid taxes. Instead, you must figure out the proportion of your total traditional IRA balances that is composed of nondeductible contributions, then use that percentage to find out how much of your conversion will not be taxable. Note that inherited IRAs are excluded in this calculation.
Keep state taxes in mind too. A Roth IRA conversion is a taxable event. If your state has an income tax, the conversion will generally be treated as taxable income by your state as well as by the federal government.
If your spouse has IRAs with mostly nondeductible contributions and you have IRAs with mostly deductible contributions, you might consider converting your spouse's IRAs before yours to reduce the potential tax impact of conversion.