Generally, all assets converted from a traditional IRA account to a Roth IRA will be subject to taxes at ordinary income tax rates. The exception to this are any contributions made on an after-tax basis. Any gains on the investments in the account, regardless of whether the contributions were made on a pretax or after-tax basis, are also subject to taxes in a Roth conversion.
Where you have traditional IRA money from after-tax contributions, pretax contributions and investment gains, calculating the amount of the conversion that is subject to taxes can become complex. This situation sometimes arises in the case of a backdoor Roth conversion to be discussed later.
It’s important to be sure that you have sufficient cash outside of the traditional IRA to cover the taxes on the Roth conversion. If you need to tap your traditional IRA to cover the tax bill, these withdrawals will be subject to taxes and potentially to a 10% penalty if you are younger than 59 ½. This could make the conversion quite expensive for you.
In next blogpost, we will discuss the disadvantages of Roth IRA conversion.