Converting Nondeductible IRA to Roth

Dear Tax Talk,

I have a traditional IRA that's 100 percent funded with post-tax (nondeductible) contributions. That account also has sizable capital gains. If I convert it to a Roth IRA, would I owe ordinary income taxes on the amount representing capital gains?

If yes and if I only do a partial conversion, would the entire amount up to my basis be tax-free, or would I owe income taxes on a pro rata amount of capital gains?

-- Joe

Dear Joe,

Congratulations on having substantially appreciated assets in your IRA. That hasn't happened for a lot of folks.

Dispel yourself of the notion of capital gains in an IRA; there is no such thing. IRAs have earnings whether they come from dividends, interest or asset appreciation. Withdrawals or conversions from an IRA result in ordinary income no matter what underlying asset generated the growth.

Unlike Roth IRAs, withdrawals from a nondeductible IRA consist of pro rata return of the principal and part of the growth. For example, if your IRA is $10,000 of after-tax contributions and $10,000 of growth, then it is equal parts contributions and growth. You would be taxed on half of the withdrawals, whether you kept the funds or converted them to a Roth IRA. The tax on the withdrawal or conversion would be computed at ordinary income tax rates, which could be higher than the maximum 15% capital gains rate.

If you had purchased the securities that are currently in the nondeductible IRA outright, your maximum tax after more than one year would be the 15% capital gains rate. For this reason, many people do not care to use a nondeductible IRA to invest in securities, as it converts capital gain into ordinary income, which can be taxed by as much as 35%.

Therefore, in a partial or total conversion, you will end up paying tax on ordinary income. If you're young, you may want to consider the conversion as you have many years ahead of you for appreciation. If you're within 10 years of retirement, I don't recommend the conversion. I've known too many cases where the client converted to lock in the gain only to later have the value of the account decrease.

Ask the adviserTo ask a question on Tax Talk, go to the "Ask the Experts" page and select "Taxes" as the topic. Read more Tax Talk columns.To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.