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Reporting Roth Conversions on your 2021 Tax Return

As we have written about previously, we are generally big fans of Roth Conversions. A Roth conversion is the act of moving money from a pre-tax retirement account to a Roth IRA.  The Roth conversion increases the taxpayer’s ordinary Federal and state taxable income the year of the conversion. 

Example of a $10,000 Roth Conversion: If one is in the 22% Federal Tax Bracket and 5.75% State and then converts $10,000 of an IRA into a Roth IRA, the result is a total tax of $2,775. *Please note that this is a simple example and the calculation can be more complex depending on the individual situation.

The tax due on the conversion can be paid by an estimated payment, normal employer withholding, or by having the tax withheld on the converted amount.  Although we typically recommend paying the tax by an estimated payment or through employer withholding, having the tax withheld on the conversion isn’t a bad idea.  However, if a taxpayer under 59.5 has the taxes withheld from the conversion, the withholding will be subject to taxes and an early distribution penalty.

Converting all or some of your IRA to a Roth IRA can be a great strategy for multiple reasons.  The goal of your conversion may be to reduce future taxes or to begin creating a tax-free legacy.  It may be as simple as diversifying your overall tax profile.  Whatever your goals may be, it’s important that conversions are reported properly so that the benefits can be fully realized.

If you executed a Roth conversion in 2021, you will receive a 1099-R reporting the distribution as taxable income.  However, your 1099-R will report not only your conversion, but will also report all other distributions from that IRA. Therefore, it is important for you to work with your tax preparer and inform them of how much of your total distribution was due to an IRA to Roth IRA Conversion.  Our custodian, Axos Advisor Services, provides a supplement to the 1099-R that shows the various distributions throughout the year, and we recommend using this schedule to help identify the converted amount(s) and date(s).

To ensure your transaction is properly recorded, your tax preparer will need to file a Form 8606 with your tax return.  This form must be filed to report a Roth conversion, and going forward will help you track the basis in your Roth IRA(s) over time.  Lastly, if you made an estimated tax payment with your conversion, please let your tax preparer know both the date that your conversion occurred and the date of your estimated payment as this will be useful information when completing your tax return. If we assisted with your conversion and estimated payment, you should not be subject to a penalty for not paying your taxes timely. Please let us know if a penalty is calculated and allow us to review the return before filing.